MBA in a Nutshell #28 - Accounting and Finance : Investment Appraisal

Today we will look at various ways to internally appraise projects in a company. These frameworks are more appropriate for business administrators but they can be modified for use by some investors.

Let us begin with common metrics :

a) Net Present Value (NPV)

NPV =  Cash Outflow - Present value of incoming cashflow

This is the most basic of all investment appraisal techniques. Where the NPV is a positive number ( such as +$10,000 ), the project is viable. Where it is negative, you are likely to be throwing good money after bad projects. This can be manipulated by projecting a different future incoming cashflow and lowering the discount rate in the calculations.

b) Internal Rate of Return (IRR)

This measure calculates the proper discount rate that would set the NPV measurement of zero. On a spreadsheet, the IRR() and XIRR() functions can perform this calculation separately. When you use IRR you no longer have the ability to manipulate the discount rate. Companies often set a hurdle rate when assessing projects using this framework. Many years ago in P&G we were told that IT projects that do not have an IRR of 15% should not be carried as P&G is better off farming the money to branding campaigns.

c) Payback period

The final measure is based on the number of years a project needs to break-even. This simply takes the investment outlay and divides it by the yield of the investment project in absolute dollars. A $100,000 project that returns $20,000 every year will reak even in 5 years. If you use this approach, projects are chosen based on how quickly they can pay you back your original investment.

The text-book goes beyond these standard measures with a scathing critique of measures created by the consulting industry. Measures like EVA and MVA are designed to distinguish consulting offerings from each other and introduces biases in measurement. For example, EVA tends to be biased towards managers who milk their companies and focuses less on growth.

The author suggests that, instead of following the latest management fad, simply using operating income divided assets into an ROI measure works best.