NDCF Methods

Session 23 & 24

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 PAYBACK
• Payback is the number of years required to recover the
original cash outlay invested in a project.
• If the project generates constant annual cash inflows, the
payback period can be computed by dividing cash outlay by
the annual cash inflow. That is:

Initial Investment C0
Payback = 
Annual Cash Inflow C

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Example
• Assume that a project requires an outlay of Rs 50,000
and yields annual cash inflow of Rs 12,500 for 7 years.
The payback period for the project is:

Rs 50,000
PB   4 years
Rs 12,500

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 PAYBACK
• Unequal cash flows- In case of unequal cash inflows, the
payback period can be found out by adding up the cash inflows
until the total is equal to the initial cash outlay.
• Suppose that a project requires a cash outlay of Rs 20,000, and
generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs
3,000 during the next 4 years. What is the project’s payback?
Year CF Cumulative CF
1 8000 8000
2 7000 15000
3 4000 19000
4 3000 22000

3000
𝑃𝑎𝑦 𝑏𝑎𝑐𝑘 = 3 𝑦𝑒𝑎𝑟𝑠 + 20000 − 19000 ÷ months = 3 years, 4 months
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Acceptance Rule
• The project would be accepted if its payback period is less
than the maximum or standard payback period set by
management.
• As a ranking method, it gives highest ranking to the project,
which has the shortest payback period and lowest ranking
to the project with highest payback period.

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Evaluation of Payback
• Certain virtues:
• Simplicity
• Cost effective
• Short-term effects: Short pay back projects adds to short term profits
• Risk shield: Short pay back projects are less risky
• Improves liquidity since projects with shorter pay back are preferred
• Serious limitations:
Cash flows after payback
Time vale ignored
Inconsistent with shareholder value

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Payback Reciprocal and Internal Rate of Return
• The reciprocal of payback will be a close approximation of the
internal rate of return if the following two conditions are satisfied:
1. The life of the project is large or at least twice the payback period.
2. The project generates equal annual cash inflows.

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DISCOUNTED PAYBACK PERIOD
• The discounted payback period is the number of periods
taken in recovering the investment outlay on the present
value basis.
• The discounted payback period still fails to consider the
cash flows occurring after the payback period.

Discounted Payback Illustrated (Discount Rate = 10%).

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ACCOUNTING RATE OF RETURN
METHOD
• The accounting rate of return is the ratio of the average after-tax profit
divided by the average investment. The average investment would be
equal to half of the original investment if it were depreciated constantly.

or

• A variation of the ARR method is to divide average earnings after taxes by

the original cost of the project instead of the average cost.

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Example
• A project will cost Rs 40,000. Its stream of earnings before
depreciation, interest and taxes (EBDIT) during first year
through five years is expected to be Rs 10,000, Rs 12,000,
Rs 14,000, Rs 16,000 and Rs 20,000. Assume a 50 per cent
tax rate and depreciation on straight-line basis.

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Calculation of Accounting Rate of Return

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Acceptance Rule
• This method will accept all those projects whose ARR is higher
than the minimum rate established by the management and
reject those projects which have ARR less than the minimum
rate.

• This method would rank a project as number one if it has highest

ARR and lowest rank would be assigned to the project with
lowest ARR.

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Evaluation of ARR Method

• The ARR method may claim some merits

Simplicity
ARR reflects profitability of the project since the entire
income streams are taken into account.
• Serious shortcomings
Cash flows ignored
Time value ignored
Arbitrary cut-off for deciding acceptability.

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REINVESTMENT ASSUMPTION : The Biggest
Drawback of IRR
• The IRR method is assumed to imply that the cash flows
generated by the project can be reinvested at its internal rate
of return, whereas the NPV method is thought to assume that
the cash flows are reinvested at the opportunity cost of
capital.

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VARYING OPPORTUNITY COST OF CAPITAL

• There is no problem in using NPV method when the

opportunity cost of capital varies over time.
• If the opportunity cost of capital varies over time, the use of
the IRR rule creates problems, as there is not a unique
benchmark opportunity cost of capital to compare with IRR.

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 Problem of Multiple IRRs
• A project may have both lending and borrowing features together.
• IRR method, when used to evaluate such non-conventional
investment can yield multiple internal rates of return because of
more than one change of signs in cash flows.
• Such projects still can have single NPV.

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Case of Ranking Mutually Exclusive Projects

• Investment projects are said to be mutually exclusive when only one

investment could be accepted and others would have to be excluded.
• Two independent projects may also be mutually exclusive if a financial
constraint is imposed.
• The NPV and IRR rules give conflicting ranking to the projects under some
conditions.

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Conflicts Between NPV & IRR
• NPV and IRR will give conflicting results under the following
circumstances:
• Unconventional cash-flows
• Lending and borrowing type of projects
• Timing and magnitude of cash-flows
• Scale of investments
• Project lifespan

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 Conventional & Non-Conventional Cash
Flows
• A conventional investment has cash flows the pattern of an
initial cash outlay followed by cash inflows. Conventional
projects have only one change in the sign of cash flows; for
example, the initial outflow followed by inflows, i.e., – + + +.

• A non-conventional investment, on the other hand, has cash

outflows mingled with cash inflows throughout the life of the
project. Non-conventional investments have more than one
change in the signs of cash flows; for example, – + + + – ++ – +.

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Lending and Borrowing Type Projects

Project with initial outflow followed by inflows is a

lending type project, and project with initial inflow
followed by outflows is a borrowing type project, Both
are conventional projects.

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Timing of cash flows

The most commonly found condition for the conflict between the
NPV and IRR methods is the difference in the timing of cash
flows. Let us consider the following two Projects, M and N.

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Project life span

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Incremental approach
• It is argued that the IRR method can still be used to choose between mutually
exclusive projects if we adapt it to calculate rate of return on the incremental cash
flows.
• The incremental approach is a satisfactory way of salvaging the IRR rule. (the
example below is based on slide 21).

• The above result shows M’s incremental cash-flows over N. Similarly, NPV and IRR of
N’s incremental cash-flows over M also can be found out.
• Finally, project with superior incremental cash-flows can be accepted.
• But the series of incremental cash flows may still result in negative and positive cash
flows. This would result in multiple rates of return and ultimately the NPV method
will have to be used.
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MODIFIED INTERNAL RATE OF RETURN
(MIRR)
• The modified internal rate of return (MIRR) is the
compound average annual rate that is calculated with
a reinvestment rate different than the project’s IRR.

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Fisher’s Intersection

NPV Profiles of Projects M and N

The NPV profiles of two projects intersect at 10 per cent discount

rate. This is called Fisher’s intersection.
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