Intermediate Financial Management (with Thomson One)

402 • Part 3 Project Valuation
Figure 12-3
Project S:
Net cash flow
Discounted NCF (at 10%)
Cumulative discounted NCF
Payback S = 2.95 years
Project L:
Net cash flow
Discounted NCF (at 10%)
Cumulative discounted NCF
Payback L = 3.88 years
Evaluating Payback and Discounted Payback
Note that the payback is a type of “breakeven” calculation in the sense that if
cash flows come in at the expected rate until the payback year, then the project
will break even. However, the regular payback does not consider the cost of capital—no
cost for the debt or equity used to undertake the project is reflected in the
cash flows or the calculation. The discounted payback does consider capital
costs—it shows the breakeven year after covering debt and equity costs.
An important drawback of both the payback and discounted payback methods
is that they ignore cash flows that are paid or received after the payback
period. For example, suppose Project L had an additional cash flow of $5,000 at
Year 5. Common sense suggests that Project L would be more valuable than Project
S, yet its payback and discounted payback make it look worse than Project S.
Consequently, both payback methods have serious deficiencies.
Although the payback methods have serious faults as ranking criteria, they do
provide information on how long funds will be tied up in a project. Thus, the
shorter the payback period, other things held constant, the greater the project’s
liquidity. Also, since cash flows expected in the distant future are generally riskier
than near-term cash flows, the payback is often used as an indicator of a project’s
riskiness.
Net Present Value (NPV)
Projects S and L: Discounted Payback Period
0 1 2 3
–1,000
–1,000
–1,000
500
455
–545
400
331
–214
0 1 2 3
4
–1,000
–1,000
–1,000
100
91
–909
300
248
–661
As the flaws in the payback were recognized, people began to search for ways to
improve the effectiveness of project evaluations. One such method is the net present
value (NPV) method, which relies on discounted cash flow (DCF) techniques.
To implement this approach, we proceed as follows:
1. Find the present value of each cash flow, including all inflows and outflows,
discounted at the project’s cost of capital.
2. Sum these discounted cash flows; this sum is defined as the project’s NPV.
3. If the NPV is positive, the project should be accepted, while if the NPV is negative,
it should be rejected. If two projects with positive NPVs are mutually
exclusive, the one with the higher NPV should be chosen.
300
225
11
400
301
–360
4
100
68
79
600
410
50