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Here I take a quick look at each one and the pro’s of con’s of using these metrics. Description – Perhaps the mostly widely used technique for analyzing a potential investment opportunity or project is the net present value of cash flow or NPV approach. Using the NPV of cash flow technique we would discount all cash flows in our business case at the opportunity cost of capital – in most cases the weighted average cost of capital for a company. Pros – Accounts for the fact that the value of a dollar today is more than the value of a dollar received a year from now – that’s the time value of money concept. Cons – Does not give visibility into how long a project will take to generate a positive NPV due to the calculations simplicity.
Our NPV rule tells us to accept all investments where the NPV is greater than zero. However, the measure doesn’t tell us when a positive NPV is achieved. Does it happen in five years or 15? Another limitation of the NPV approach is that the model assumes that capital is abundant – that is there is no capital rationing. Description – The internal rate of return, or discounted cash flow rate of return, offers analysts a way to quantify the rate of return provided by the investment.
The internal rate of return is defined as the discount rate where the NPV of cash flows are equal to zero. Pros – It is widely accepted in the financial community as a quantified measure of return and it’s also based on discounted cash flows – so accounts for the time value of money. Multiple or no Rates of Return – if you’re evaluating a project that has more than one change in sign for the cash flow stream, then the project may have multiple IRRs or no IRR at all. Changes in Discount Rates – the IRR rule tells us to accept projects where the IRR is greater than the opportunity cost of capital or WACC. But if this discount rate changes each year then it’s impossible to make this comparison. IRRs Do Not Add Up – one of the strengths of the NPV approach is that if you need to add one project to an existing project you can simply add the NPVs together to evaluate the entire project.
IRRs on the other hand cannot be added together so projects must be combined or evaluated on an incremental basis. Description Payback allows us to see how rapidly a project returns the initial investment back to the company. In practice, companies establish “rules” around payback when evaluating a project. For example, a company might decide that all projects need to have a payback of less than five years.