Summary

The payback period is the simplest project evaluation method. It is the time it takes the company to recoup its initial investment. Its usefulness is limited, however, because it ignores the time value of money.

Net present value (NPV) is calculated by subtracting the present value of a project’s cash outflows from the present value of the project’s cash inflows. A project should be accepted if its NPV is positive and rejected if its NPV is negative.

The internal rate of return (IRR) of a project is the discount rate that sets the present value of a project’s cash inflows exactly equal to the present value of the project’s cash outflows. A project should be accepted if its IRR is greater than the firm’s cost of attracting capital.

The discounted payback period uses the time value of money to discount future cash flows to see how long it will be before the initial investment of a project is recovered. MIRR provides a variation on IRR in which all cash flows are compounded using the cost of capital, resolving the reinvestment rate assumption problem of the IRR method; unlike IRR, which may have multiple mathematical solutions, MIRR will result in one solution. The profitability index is calculated as the NPV of the project divided by the initial cost of the project.

Firms may need to choose among a variety of good projects. The projects may have different lives or be differently sized projects that require different amounts of resources. By choosing projects with the highest profitability index, companies can take on the projects that will lead to the greatest increase in value for the company.

Excel spreadsheets provide a way to easily calculate the NPV and IRR of a project. Using Excel to create an NPV profile allows a company to see how much its estimates of the cost of raising funds can err from the true cost and have the project still be an acceptable project.