Let me help you improve your understanding of Net Present Value, Internal Rate of Return, and the payback method, by running various scenarios and analyzing the impact on NPV, IRR and payback.

Meet our project manager, Jane. She is working on an investment project for her site. Besides working on the technical specifications, she needs to put the numbers together to get approval to move ahead with the project. After working with various suppliers and the Operations Manager, Jane has come up with the following estimates for the “Base Case” of the project. The expected upfront investment is $1000, which is cash out. The expected benefits are $400 per year, for four years, which is cash in. Jane has documented her assumptions, and feels that these estimates are reasonably accurate.

⏱️TIMESTAMPS⏱️
0:00 Investment project assumptions
0:58 NPV IRR payback period explained
2:07 Improving financial attractiveness of a project
3:09 Comparing project alternatives
3:44 NPV IRR payback period vs base case
5:53 NPV IRR payback maximization

Jane inputs her numbers into a spreadsheet that she received from a finance colleague. With a 20% discount rate (or WACC) that is used for investment projects in the company, the project has a Net Present Value (NPV) of $35, an Internal Rate of Return (IRR) of 22% and a payback period of two and a half years. What do these numbers mean? NPV needs to be bigger than zero, which at $35 it is. Internal Rate of Return needs to be higher than the discount rate: 22% for the project is higher than the 20% discount rate. Payback period is 2.5 years. Jane wants to make sure the numbers are calculated correctly, so she checks the Excel formulas for NPV, IRR and payback period, which seem to be working fine. After these verifications, Jane submits her project for approval. She doesn’t get an immediate “yes” or “no”, but hears the words that every project manager dreads: “You can do better than that…”.

Jane is at a loss. What does she do now? There are several ways to improve the financial attractiveness of a project, based on more optimistic assumptions. To make it easy to compare these, each of the improvement ideas is worth $100 on a nominal basis. The first idea, let’s call it A1, is to reduce the spending on the initial investment. Jane changes the scope of the investment without losing functionality and benefits, saving $100. The second idea, A2, is to find additional benefits of $25 per year in each of the four years. Incremental savings that she may have overlooked in the first draft of the project. The third idea, A3, is to extend the benefits: one quarter in year 5. Which of these variations on the original project do you prefer, or are they all equal?

Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better #investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!