Project Appraisal
Payback
Simple the time taken to pay back the original investment, ignoring inflation and the time value of
money. Any cash inflows after payback are ignored
Advantages
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Simple
Uses readily available accounting data
Shortest payback = lowest risk
Faster payback has favourable short-term effect on earnings per share
Disadvantages
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Ignores time value of money
Indifferent to the timing of the cash-flow (if payback time equal)
Takes no account of what happens after payback period
Does not quantify risk
NPV
Measures the cash inflows and outflows over the life of the projects. Uses the discount factor to
adjust the fl9ows to their ‘present value’. Compares the present value of the outflows to the inflows
to give the net present value. If NPV > 0, then the project adds value for the company’s shareholders
provided capital is not rationed, company should undertake the project
Advantages
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Introduces time value of money
Expresses future cash-flow in today’s values
Allows for inflation and escalation
More accurate profit & loss forecast
Used for simulation
Disadvantages
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Accuracy limited by predictions of cash-flow and inflation
Biased towards short-term projects
Excludes non-financial data, e.g. market potential
(Removed the bullet stating that the disadvantage of NPV was that it used a fixed interest rate as
this was incorrect)
IRR
Internal rate of return, IRR, is the value of the discount rate R that makes NPV = 0. If the IRR is equal
or greater than the company “hurdle rate” then the project creates value.
Advantages
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IRR is a measure of profitability established by the capital markets (hurdle)
IRR gives an indication of the actual rate of return for the project
Disadvantages
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More complex than NPV
Accountants prefer NPV to IRR because the interest rate can be varied with NPV
Accuracy limited by predictions of cash-flow
Excludes non-financial data, e.g. market potential
Determining a discount factor
Discount rate R is the opportunity cost of capital
A firm could use
R = Rf + Ri + Rr
Where:
R is the discount rate, Rf the risk free interest rate. Ri Rate of inflation. Rr Risk factor consisting of
market risk, industry risk, firm specific risk and project risk. Example: If risk free interest is 5%,
inflation 3% then nominal rate of interest is 8%. In addition if we add 5% risk premium then our
discount rate is 13%.
However, most companies are financed partly by equity (owned by shareholders) debt (owned by
lenders). In general, equity is more risky than debt interest payments on debt must be paid, whereas
dividends can be cut or not paid. As a result, shareholders demand a higher rate of return from their
investment than do lenders cost of equity is higher than cost of debt. Hence R might underestimate
the return needed.
Weighted Average Cost of Capital (WACC) reflects the split (by market value) in company’s financing.
It measured by:
WACC  (proportion of debt)  (cost of debt)
 (proportion of equity)  (cost of equity)