Forward-looking business people are mindful of the fact that the evaluation of risks associated with projects is a challenging task due to a large number of variables that should be taken into account. One of such variable is the future value of money that should be considered when engaging in entrepreneurial endeavors. This value is referred to as net present value (NPV) or present net worth (NPW) (Scott, 2016). Other variables used to compare the attractiveness of financial projects are the internal rate of return, payback period or payback method, and average accounting rate of return (Brief, 2013). The aim of this paper is to discuss these measures with respect to capital budgeting and exemplify their application in practical terms.
The NPV is a measure of return on investment (ROI) calculation through the subtraction of the present value (PV) of cash outflows from the PV of cash inflows over a certain rate of return (Frino, Hill, & Chen, 2013). When used in capital budgeting, the method of assessing capital investments is associated with a significant advantage. Specifically, the key benefit of using the NPV is that it accounts for the time value of money. It is extremely important since the profitability characteristics of a financial endeavor can change over time to a substantial extent under the eroding effect of inflation.
The calculation of NPV necessitates the following inputs: projected net cash inflow from a project over a time period t (Ct), total investment costs (C0), discount rate (r), and the number of periods (t). Thus, the formula for the calculation of the measure can be expressed as follows:
When it comes to a single project, a positive NPV suggests that its generated earnings will surpass its projected costs (Frino et al., 2013). In the case of competing projects, it is recommended to opt for one with a higher NPV (Frino et al., 2013). For example, a restaurant chain considers opening a news outlet that necessitates an initial investment of $245 000. To understand whether the project should be accepted, a calculation of the future cash flow from the outlet is needed with the subsequent discount (r) to arrive at a lump-sum present value (Frino et al., 2013).
If the said value is $400 000, the project will be associated with a positive investment because the NPV during the calculated investment period will be equal to $155 000. Total investment costs (C0) of $245, 000 should be subtracted from the lump-sum present value of $400 000, which results in the positive NPV. The result shows that the opening of the new outlet is a profitable investment.
The payback method is another approach to calculating ROI over a period of time. However, it is much simpler than the NPV method because it does not consider the value of money over time. Therefore, its use is recommended for short-term investment projects, which are less likely to be influenced by the eroding effect of inflation (Scott, 2016). The formula for the calculation of payback period using the payback method can be expressed as follows:
Payback period = years of full recovery + cash outlay at the beginning of last year/ cash flow in the next year
To exemplify the application of the method, consider a company that estimates the payback period of two pieces of equipment: A and B. A costs $60, 000 and it is estimated that cash flow produced from its purchasing will equal to $12 000 per year. By applying the formula, it can be established that the payback period for the investment in A is five years. If the company can acquire only one piece of equipment and the estimated payback period for B is four years, it should opt for the second option.
Internal Rate of Return
Internal rate of return (IRR) is another measure of a project’s profitability over time. The metric is used in conjunction with a company’s required rate of return. If the latter exceeds the formal, the project is considered desirable and should be pursued by the company. The formula for calculating IRR is the same as one used for the estimation of the NPV. However, the NPV should be equal to zero and be solved for r (Scott, 2016).
If the company decides on purchasing a machine for $500, 000, which will function for five years and generate $210 000 of profit during the period and can be resold for $50 000 at the end of the period, IRR would equal 23 percent. Assuming that other investment options are associated with a lower return, the company should buy the machine.
The Average Accounting Rate of Return
The average accounting rate of return (ARR) is a metric similar to the NPV. To calculate the ARR, it is necessary to divide the average expected profit from an investment option by its cost. For example, the total return from the option over a period of three years is 20, 000. If the investment amounts to 100 000, then the ARR would be equal to 20 percent.
The paper has discussed the NPV, the payback method, the IRR, the ARR, and made examples of its use. It has been argued that these methods can be effectively used to estimate the attractiveness of projects that can be pursued by businesses.
Brief, R. P. (2013). Estimating the economic rate of return from accounting data. Abington, England: Routledge.
Frino, A., Hill, A., & Chen, Z. (2013). Introduction to corporate finance (5th ed.). London, England: Pearson.
Scott, P. (2016). Accounting for business (2nd ed.). Oxford, England: Oxford University Press.