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    Capital Budgeting - Payback, NPV, PI, IRR

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    Can someone please describe the following project evaluation processes for me: Payback, NPV, PI, IRR. Is any one evaluation process better the others? Why?

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    Please see the attached file.

    Can someone please describe the following project evaluation processes for me: Payback, NPV, PI, IRR. Is any one evaluation process better the others? Why?

    Project appraisal methods are:

    ? Traditional methods:
    Payback Period method
    Accounting rate of return method

    ? Discounted Cash flow (DCF) methods:
    NPV (Net Present Value) method
    IRR (Internal Rate of Return) method
    Profitability index

    A) Payback Period:

    Payback time or payback period is the time it will take to recoup, in the form of cash inflows from operations, the initial amount invested in a project. The shorter the payback period, the better it is. To apply the payback period criterion, it is necessary for management to establish a maximum acceptable payback value PP*. In practice, PP* is usually between 2 and 4 years.

    In determining whether to accept or reject a particular project, the payback period decision rule is:
    Accept if PP < PP*
    Reject if PP > PP*
    Indifferent where PP = PP*

    For mutually exclusive alternatives accept the project with the lowest PP if PP<PP*

    To calculate the Payback Period:
    ? If the cash flows are an annuity, then we can simply divide the cost by the annual cash flow to determine the payback period
    ? Otherwise, we calculate the cumulative cash flow and note when it becomes positive.

    Example 1: A firm is considering the purchase of a new machine that will cost $ 70,000 and last five years. The machine will increase profits by $20,000 per year. Calculate the payback period.

    Since the cash flow is an annuity,
    Payback period = $70,000 / $20,000 = 3.5 years

    Example 2: Suppose the cash flow for a project is as follows:

    Initial investment = $10,000
    Year 1-5 cash inflows:

    Year Cash flow
    1 $2,000
    2 $2,500
    3 $3,000
    4 $3,500
    5 $4,000

    Calculate the payback period.

    The cash flow is not an annuity, therefore we employ a different method. We calculate the cumulative cash flow.

    Year Cash flow Cumulative cash flow

    0 (10,000) (10,000)
    1 2,000 (8,000)
    2 2,500 ...

    Solution Summary

    The project evaluation techniques for capital budgeting-Payback, NPV, PI, IRR,P rofitability Index (PI)- are discussed.

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