Framework library · Finance and valuation
Investment appraisal: NPV, IRR and payback
Investment appraisal sets the cash a project costs against the cash it returns, adjusted for when each arrives. Net present value says how much value the project adds at the business's hurdle rate, the internal rate of return says what return it earns, and payback says how long the money is at risk. A project is worth doing when its NPV is positive at the hurdle rate.
Use it when
- A project needs capital now and pays back over several years, such as replacing diesel generators with solar power and batteries at off-grid sites.
- Several projects compete for one capital budget and need to be ranked.
- Finance has set a hurdle rate and you need to show whether a project clears it.
- Two ways of doing the same thing have different timing, such as buying equipment or leasing it.
Avoid it when
- You are valuing a whole business or a stake in one. Use DCF valuation, which values free cash flow to all investors and includes a terminal value.
- The project's value depends on decisions made later, such as expanding only if a pilot works. Use decision tree analysis so the option is valued.
- The cash flows change sign more than once. IRR can then have several answers or none; rely on NPV.
- The options deliver the same benefits and differ only in cost. Total cost of ownership is simpler.
How to run it
Write the cash flows by year
Year 0 is the initial investment. Include only cash that changes because of the project: savings, new revenue, extra running costs, replacement spending, and any value left in the assets at the end.
Set the hurdle rate
The return the business requires for a project of this risk, usually its cost of capital plus a margin. Finance should set it, not the project team.
Calculate NPV
Discount each year's net cash flow at the hurdle rate and add them up. A positive NPV means the project earns more than the hurdle.
Check IRR and payback
IRR is the rate at which NPV is zero; compare it with the hurdle. Payback is the number of years until the cumulative cash flow turns positive. A long payback means more exposure to things changing.
Test the assumptions that matter
Move the largest benefit and the largest cost by plausible amounts and see whether the decision changes. Use sensitivity analysis for a fuller test.
Work through it
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Mistakes to avoid
- Ranking projects of different sizes by IRR. A small project with a high IRR can add less value than a large one with a lower IRR. Rank by NPV.
- Ending the cash flows where the spreadsheet ends. If the assets last beyond the final year, add what they are worth then as a benefit in that year.
- Treating payback as a measure of value. It ignores everything after the payback year. Discounted payback is stricter but has the same blind spot.
- Including sunk costs, or overheads that do not change with the decision, which can turn down a project that would add value.
Where it comes from
The present-value arithmetic is set out in Irving Fisher, The Theory of Interest (1930), whose "rate of return over cost" is the forerunner of the internal rate of return. Joel Dean's Capital Budgeting (Columbia University Press, 1951) brought these methods into decisions about corporate investment. Source.
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