The NPV, IRR and payback period all are used in the evaluation process of a project. All of the three are the main techniques of capital budgeting. The Net Present Value (NPV) discounts all the future cash flows of the proposed project at a determined discount rate (i.e. WACC) and determines their present values. The Internal rate of return determines the percentage rate of return at which those same cash flows gives the Net Present Value equal to zero. The payback period is simply just the length of the time required to cover the project's initial investment outlay or in more simple words it is the length of time an investment reaches a breakeven point.

There are the following

differences between the three methods as explained below:

1. The NPV and IRR both

use the discounting method on future cash flows, but the payback method does

not use discounting method on future cash flows.

2. The NPV gives the

outcome in terms of dollar value that the project is expected to produce; the

IRR gives the outcome in terms of percentage that the project is expected to

create, and the payback period gives the outcome in terms of time.

3. A discount rate is

always required to calculate the NPV but there is no such requirement under IRR

and payback period.

4. NPV and IRR both

consider the concept of the time value of money but it is not the case in the

payback period.

5. IRR and payback

period may give misleading results when there is a major outflow in the future

time of the project.

6. Modified IRR and discounted

payback period, are the extended versions of the IRR and payback period,

respectively. There is no such extended version of NPV that exists till now.

7. The NPV and IRR can be used when the company wants to accept or reject the project, or to compare

two or more projects but, the payback period can only be used when the company

wants to compare the projects.

Required 1. Calculate the net present value and internal rate of return for this investment. 2. Assume that the finance manager of Meriton is not sure about the cash revenues and costs. The revenues could be anywhere from 15% higher to 15% lower than predicted. Assume cash costs are still $12 000 per year. What are the NPV and IRR at the high and low points for revenue? 3. The finance manager thinks that costs will vary with revenues, and if the revenues are 15% higher the costs will be 10% higher. If the revenues are 15% lower, the costs will be 10% lower. Recalculate the NPV and IRR at the high and low revenue points with this new cost information. 4. The finance manager has decided that the company should earn 4% more than the cost of capital on any project. Recalculate the original NPV in requirement 1 using the new discount rate and evaluate the investment opportunity. 5. Discuss how the changes in assumptions have affected the decision to expand.

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