Most businesses have a choice of a range of investment projects and they need to have a basis for comparing them to evaluate which is the best. Here are the most widely used methods for assessing candidate projects in terms of their return performances.
Payback period
The payback period is the simplest tools for appraising different investment projects. To be able to compare projects we need to have information on how much the project costs and the expected net cash flows or income streams that it is likely to generate over its lifetime. Following is an example to this method.
Let's say that a firm is planning to install a new computerized stock control system. The expected net cash flow (income less expenses) from the system is as follows and the expenses to be incurred for this system is £250,000.
| Year | 1 | 2 | 3 | 4 | 5 |
| Net cash flow | 50,000 | 65,000 | 65,000 | 70,000 | 75,000 |
We can see that the payback period on this system is exactly four years. This is because cumulative returns for the first 4 years of this project is equal to the cost of it. One can do this analysis in terms of months as well, if the figure does not come out as an exact number of years.
Average rate of return
The average rate of return, like the payback period method, looks at the expected net cash flows (income - expenses) of the investment project. It then measures the average net return each year as a percentage of the initial cost of the investment. Let's look at an example. A firm is looking at buying a new automatic painting machine. The cost of the machine is 200,000 and the expected net cash flows are:
| Year | 1 | 2 | 3 | 4 | 5 |
| Net cash flow | 50,000 | 55,000 | 65,000 | 75,000 | 75,000 |
The total return from the project over the five years is 320,000 (the sum of the five years). If we subtract the original cost of 200,000 from this, we get the net return from the investment to be 120,000. This took 5 years to earn and so the annual return is 120,000 divided by 5 which is 24,000 per annum. To get the average rate of return, we use the following formula:
| Net return per annum |
From the figures above this gives us:
Average rate of return = 24,000 x 100 / 200,000 = 12%
This suggests that every £1 worth of investment yields an average 12p return each year
Discounted cash flow
Discounted cash flow (DCF) is the most realistic of the three methods, but has the main advantage that it takes account of the fact that returns in the future may be worth less than the same return now. As a result of this it may gives us far less amount of return than the other methods are projecting.
To use this to value an investment project, we would go through the following steps:
- Choose an estimated discount rates for the years that project is run (this may depend on expected future interest rates in the market).
- Find the present values by multiplying the expected net cash flows with their discount factor.
- Add together all the present values from step 2 and subtract the capital cost to give us the net present value.
Let's do an example to see how this works. A firm is thinking of buying a machine costing £200,000 and the expected net cash flows are:
| Year | 1 | 2 | 3 | 4 | 5 |
| Net cash flow | 50,000 | 55,000 | 65,000 | 75,000 | 75,000 |
If we follow the three steps above, we will get:
Step 1
Let's choose a discount rate of 10%. This means that our discount factors are:
| Years in future | 1 | 2 | 3 | 4 | 5 |
| 10% | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
Step 2
If we multiply the expected net cash flow by the discount factor, we get:
| Year | 1 | 2 | 3 | 4 | 5 |
| Net cash flow | 50,000 | 55,000 | 65,000 | 75,000 | 75,000 |
| 10% | 0.909 | 0.826 | 0.751 | 0.683 | 0.621 |
| Present value (£) | 45,450 | 45,430 | 48,815 | 51,225 | 46,575 |
Step 3
If we add all these present values together and subtract the capital cost, we get:
£237,495 - £200,000 = Net present value of £37,495
This represents quite a small return of 18.7% (37,495/200,000) over 5 years on the original investment. The average rate of return calculation gives us a result of 12% per annum on these same figures and so discounting the future value of returns does give a very different picture.
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