Perspective of financial economics
From the perspective of financial economics, the fundamental goal of a firm is to maximize its market value. Therefore, it is crucial to choose an appropriate investment appraisal method, in order to select these projects that would generate most wealth for the firm. Evidence1 suggests that, NPV (net present value), IRR (internal rate of return), and payback period are the three most popular method used by companies in decision-making. In this essay, the three methods would be discussed individually and compared with each other.
NPV The creation of NPV method could be counted as a milestone in invest appraisal, as it not only takes into account the time value of money, future growth of company’s value as well as the risk of the cash flow2, but also provide the most accurate result among all return-based appraisal method. This method is based on the concept of time value of money, i.e. $100 today is more valuable than $100 in future. We can calculate the FV (future value of money) by using this equation: In this equation above, ‘r’ stands for the discount rate, which consists of a tremendous range of factors, like opportunity cost, cost of capital, risk premium and inflation rate, And the
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The criteria for project selecting are fairly easy by using NPV method: we should only accept these projects with positive NPV, and reject these with negative NPV. In other words, only project with positive NPV will grow a company’s market value. Furthermore, the NPV criterion is the criterion most directly related to stock prices (CFA curriculum, 2011, p26), as it measures the value of tock increased by the project’s NPV. For example, an analyst could learn of a positive NPV project, but if the project’s profitability is less than expectations, this stock might drop in price on the news.
In addition, another concept worth noticing is ‘NPV profile’. It is a graphic method to show a project’s NPV as a function of various discount rates, which provides us a clear way to compare NPV among projects. In some circumstances3, the NPV curves can cross, and the choice of investment projects should depend on the discount rate.
IRR As a discount cash flow method, IRR, like NPV, can reflect the time value of money as well. However, instead of depending on extrinsic factors, internal rate of return is merely a discount rate that generates a NPV of zero. It can be calculated as follow (Need use a financial calculator): This rate is used to be compared with the require rate of return, which estimated by company itself based on either operating target or empirical test. Generally speaking, any project with an IRR greater than companies’ require rate of return, is acceptable.
However, when we dealing with non-conventional cash flows, i.e. not all future cash flow are positive, we might have more than one IRRs. In this case, we can use modified IRR method to calculate really IRR, but it needs borrowing and investing rate for doing so. Steps: 1. Calculate the NPV of all cash outflows using the borrowing rate. 2. Calculate the NFV of all cash inflows using the investing rate.
3. Calculate r by the equation: Payback Period Payback period method is the only method, in this essay’s discussion, which not based on discount cash flow. It is the number of years required to recover the original investment in a project. (CFA curriculum, 2011, p.12) It can be calculated as: This method is popular among CFOs, due to its simplicity in both understanding and communicating. Instead of having a restricted criterion, unlike NPV or IRR, whether to accept a certain project merely depends on a company’s own target payback period.
The main argument against payback period method is that it fails to consider the time value of money. In other words, we are not actually ‘breakeven’ in that breakeven point calculated by payback period method, but have lost amount of money due to the cost of capital or inflation. Therefore, by using discounted cash flow, people try to improve the traditional payback period method to develop a new method, called discounted payback period method. In general, the discounted payback period is always greater, and more accurate, than payback period.