Project appraisal test for business take-off – Part 2
Continued from yesterday
But sometimes, the back period, maybe sometimes during the year. In such a situation, to actually determine the period will be as follows. For example, a project of ₦150,000 as the initial cost with the following returns in years 1 to 6, ₦40,000, ₦45,000, ₦47,000 ₦43,500, ₦37,500 will be calculated thus:
Initial Investment ₦ Balance: ₦
Year 1 profit 40,000 110,000
Year 2 profit 45,000 65,000
Year 3 profit 47,000 18,000
Year 4 profit 43,500 25,500
The Payback period = 3 years + 18,000 / 43,500 X 12 = 3 years 5 months.
The payback period is also straightforward to calculate and understand in that it does not require many complications. It does not require severe technicality and, as such, can be easily used by anybody. When more than one project is considered, the project with the shorter payback period is the most profitable.
Another advantage of this technique is that it cushions the effect of uncertainty with future estimates as projects with too long a payback period may not be considered.
There is, however, the need to have a standard period that an organisation will regard as its average payback period. This is a challenging thing to decide.
It is also factual that cash flows are connected with the type of operations involved in and hence ranking projects of different nature may be misleading. A poultry farmer will generate more early income than a plantation farmer and comparing them at the initial stage may be unjust.
Like everything human with shortcomings, the payback period, even at that, provides some valuable guidelines in project appraisal.
Discounted cash flow techniques
These are techniques that take into consideration the time value of money. Projects under this technique are appraised, discounting the income generated at the company’s cost of capital rate. Primary methods under the technique are Net Present Value and Internal Rate of Return.
The Net Present Value (NPV) measures what a unit of naira today will be worth at a future date. The sum total of income generated will then be deducted from the amount initially invested to give the Net Present Value.
A Positive NPV means that the project is profitable and hence should be accepted. In contrast, a negative NPV, on the other hand, points to an unprofitable project that should be rejected. However, a zero NPV means that the project is at the break-even point and as such, acceptance or rejection will depend on the decision maker’s attitude.
Internal Rate of Return (IRR) is used to determine the rate at which a project will be at zero point, i.e., at a break-even point, and any such projects that have a higher return are regarded as profitable
The most significant advantage of discounted cash flow techniques is that it takes into consideration the time and value of money. It also considers cash flow throughout the entire life of the project.
Between NPV and IRR, there can be some conflicts. However, results provided by NPV are more reliable as IRR itself uses trial and error techniques.
In conclusion, despite any shortcomings of particular techniques a company may wish to adopt, the importance of appraising projects before they are ever accepted cannot be over-emphasized. If this had been the norm rather than the exception, businesses collapse would not have been as rapid as we are witnessing today.
Oluwadele is a chartered accountant and Public Policy scholar based in Canada. He is the author of “Thoughts of A Village Boy.”