SC QUALITY GUILDNPV, IRR and payback
SCQUALITYGUILD.COM/TOOLS/FINANCIAL-ANALYSIS-NPV-IRR.HTML
Compare investment options on net present value, internal rate of return, payback, ROI and profitability index, with an NPV profile chart and checks on the usual traps.
ON THE EXAM · CMQ/OE III.A.5 · FREE · NOTHING YOU TYPE LEAVES YOUR BROWSER
Q-BotClick for an explanation of this tool.For educational use. This page is a study aid. The method behind it has far more depth and detail than one page and one tool can cover, and what you see here is not everything the method offers or everything this site offers. For full understanding and application, use the governing standards and texts, and seek further education, training or qualified advice. Results depend on the data you enter, so check them before relying on them.
Time value of money
A dollar received next year is worth less than a dollar today, because today's dollar could be invested at the organization's cost of capital. Discounting converts each future cash flow to its present value: divide by (1 + r) raised to the number of years. The discount rate is normally set by finance as the cost of capital or a hurdle rate.
The measures
- Net present value (NPV): the present value of all future cash flows minus the initial investment. Positive NPV means the project returns more than the discount rate.
- Internal rate of return (IRR): the discount rate at which NPV is zero. Accept if IRR is above the hurdle rate. It has no formula; it is found by trial, as this tool does.
- Payback: years until cumulative cash flow repays the investment. Discounted payback does the same with discounted cash flows, so it is never shorter, and longer whenever the discount rate is above zero.
- ROI: total net gain divided by the investment. Profitability index: present value of future cash flows divided by the investment; above 1.0 means NPV is positive.
- Return on assets (ROA): net income divided by total assets, a measure of how well the whole organization uses what it owns.
When the measures disagree
NPV and IRR can rank projects differently when projects differ in size or in the timing of their cash flows. A small project with fast returns can have the higher IRR while a larger one adds more dollars of value. For mutually exclusive projects, choose by NPV: it measures value at the real cost of capital, while IRR implicitly assumes reinvestment at the IRR. When cash flows change sign more than once, for example a removal cost at the end, there can be more than one IRR, and IRR should not be used. Payback and simple ROI ignore the time value of money and are best treated as risk and liquidity checks.
Budgets and variance
Once a project is funded, its budget becomes the baseline. A variance is actual minus budget; it is favorable when costs come in under or benefits over. Investigate the large and the persistent variances, not every one.
On the CMQ/OE exam
Expect to calculate a payback period or simple NPV by hand, to pick the project to fund from a table of NPV, IRR and payback, and to explain why NPV is preferred when they conflict.