The pay-back
rule
The payback period
of a project is found by counting the number
of years needed before cumulated forecast
Cash Flows equals the initial investment.
IRR rule
The IRR is defined
as the rate of discount which makes NPV=0.
It means that to find the IRR for an investment
project lasting "n" years,
we must solve
for IRR in the following expression:
| -
FCF0
|
=
|
FCF1 |
+.....+
|
FCFn |
(1+IRR)1 |
(1+IRR
) n |
NPV rule
Click here :
NPV
Investments projects
:
Note : All investments
must increase shareholder wealth.
Projects |
FCF0 |
FCF1 |
FCF2 |
FCF3 |
FCF4 |
Pay-back |
NPV |
IRR |
A |
-1000 |
500 |
500 |
300 |
- |
2 |
93.16 |
15.66 % |
B |
-1000 |
300 |
300 |
400 |
500 |
3 |
162.69 |
16.64 % |
C |
-1000 |
400 |
300 |
300 |
400 |
3 |
110.17 |
15.03 % |
D |
-1000 |
380 |
370 |
250 |
460 |
3 |
153.25 |
16.83 % |
Opportunity Cost
of Capital : 10 %
Opportunity
Cost of Capital :
Caution
: Some people confuse the IRR and the OCC.
The IRR is a profitability measure
which depends solely on the amount and timing
of the projects FCF. The OCC is a
standard of profitability for
the project which we use to calculate how
much the project is worth. The OCC is established
in capital markets. It is the expected rate
of return offered by other assets equivalent
in risk to the project being evaluated.
Comments
If the firm used
the payback rule with a 2-year cut-off period,
it would accept only project A. If it used
the payback rule with a 3-year cut-off period,
it would accept A, B, C & D.
Therefore, regardless of the
selected cut-off period, the payback rule
gives a different answer from the NPV rule.
The reason for the difference is that payback
gives equal weight to all FCF before the payback
date and no weight at all to subsequent FCF.
According to payback rule,
if the selected cut-off period is 3 years,
projects A, B, C and D are all equally attractive.
According to NPV rule,
only project B must be accepted because it
has a higher NPV than either A, C or D.
According to IRR
rule, only project D must be accepted.
Which rule
to choose ?
Pays-back
: insufficient, as explained obove. The use
of this rule may lead to silly decisions.
IRR : If
Correctly used, the IRR rule should always
select those projects that increase shareholder
wealth. But The IRR rule contains many pitalls
and may lead to wrong decisions.
NPV : The
use of the NPV rule gives us the main
answer : project B creates the
highest value for shareholders. The NPV rule
contains no pitfalls and always lead to the
right decision.
Principles of Corporate Finance, 8th edition, Richard A. Brealey & Stewart C. Myers, McGraw-Hill
Corporate
Finance Course, Bernard Jaquier, Professor
of Economics & Finance, Lausanne, Switzerland, 2018
