Net Present Value (NPV)

It is a discounted cash flow technique. The cash flows of a project over its life are discounted at a specified rate. The difference of present value of cash inflow and present value of cash outflow is the net present value. If the present value of total benefits is higher than the present value of total costs, the project is acceptable. The NPV must be positive.

• Formula, tables and computer programs are available to calculate net present value.
• The formula for calculating net present value is:

where, PV = Present value, k = discount rate, n = number of years

Advantages of NPV

• It considers time value of money.
• It considers cash flow over the total life of the project.
• The discount rate is specified.

Disadvantages of NPV

• The discount rate may not be realistic.
• Its calculation is not easy.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is a discounted cash flow techniques. The discount rate is not specified. The trial and error method is used to find the discount rate which equates the present value of  cash outflows and cash inflows to zero. IRR is the rate where net present value is zero. If the internal rate of return is greater than the required rate of return, the project is acceptable. The cost of capital generally servers as the indicator of the required rate of return.

• Formula, annuity tables and computer programmes are available to calculate internal rate of return. Computer can do seconds where people take hours to calculate IRR.
• The formula for calculating Internal Rate of Return is:

where R= Cash Flow, r = discount rate, n = number of years

Advantages of IRR

• It  considers time value of money.
• It considers cash flow over the total life of the project.
• Comparison of IRR with cost of capital considers the risk factor.

Disadvantages of IRR

• It is complex and difficult to use.
• The discount rate is not fixed.
• It needs to be used carefully for evaluating exclusive projects.

Pay Back Period (PBP)

It measures the period of time required for the cost of a project to be recovered from the earnings of the project (annual cash flow). The main concern is the recovery of initial outlay.

Example:

       Original project cost               $500,000

       Earning per year                     $100,000

       Pay Back Period                      5 years

• The shorter the pay back period, the better the project.

Advantages  of Pay Back Period (PBP)

• It is easy to operate and simple to understand.
• It considers  earnings from the project for the payback period. The uncertainty is reduced.
• Loss through obsolescence is reduced. Short pay back period reduces risk.
• It serves as a standard to compare profitability of alternative projects.

Disadvantages of Pay Back Period (PBP)

• It does not consider cash flow after the pay back period.
• Time value of money is not considered.
• It ignores uneven profits from various projects.

Return on Investment (ROI)

The return on capital employed is used as a criterion for making investment decisions. Net capital employed, consisting of total assets minus current liabilities, is used to calculate the return Net profit is used as return.

• Satisfactory return is influenced by the nature of business, risks involved, comparative return from fixed deposit in Banks, and external economic conditions.
• If the ROI is satisfactory, the project is accepted.

Advantages of ROI

• It is simple to calculate, operate and understand. 
• It considers the cash flow throughout the life of the project.
• It serves as a standard to compare profitability of alternative projects.

Disadvantages of ROI

• It ignores time value of money.
• It is difficult to define what is satisfactory rate of return.
• It ignores varying profit from various projects.