Payback, NPV anf IRR

System
System Posts: 100,534 🤖 Admin 🤖
edited June 18 in AAT student discussion
Can anyone give me an easy description of the above mentioned topics.

I am sitting a simulation tomorrow and this might come up in it ie write short memo about these topics

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  • System
    System Posts: 100,534 🤖 Admin 🤖
    Re:Payback, NPV anf IRR

    Payback: An Investment Appraisal method used to determine the LENGTH of TIME an investment will pay it self off (ignores time value of money).

    NPV: An Investment Appraisal technique which tries to bring future cash flows from an investment to present values (today/now values) in an attempt to assess if the investmnet will make sufficient returns to justify the wait for such future funds.

    Positive NPV means proceded, Negative values mean do not proceed as it means lesser retuns after 'inflation' effect is adjusted or some choose to say 'cost of finance' adjustment.

    I like to see it as return after 'inflation effect'.

    IRR: The most likely discussion topic in the AAT exam. The RATE of RETURN expected from an investment which is assessed to the benchmark return EXPECTED by management.

    If above benchmark - say 10% accept project else reject.

    Hope this helps.

    Good luck Mate.

    Goldsmith IBS 8)
  • System
    System Posts: 100,534 🤖 Admin 🤖
    Re:Payback, NPV anf IRR

    Just to add on the excellent reply by Goldsmith:

    IRR = it is the cost of capital % (described by Goldsmith as cost of finance) where the NPV of the project would be zero. e.g. if the NPV of the project was 1000 pounds using a discount factor of 10%, what discount factor would you have to use to result in an NPV of 0.

    BUT I would have to disagree with goldsmith on the cost of capital being the inflation factor. If a project had a positive NPV even after using a discount factor for inflation you still might not accept it - companies that only return inflation are not actually generating any money for dividends. The cost of capital must be at least what the investor could gain in a deposit account at a bank and is more likely to be what the market expects on their investment.
  • System
    System Posts: 100,534 🤖 Admin 🤖
    Re:Payback, NPV anf IRR

    I think the previous replies have done an excellent job, so please don't let my comments confuse at all.

    I recently used the following expression with some students who were struggling with present values.
    Imagine that you could invest in a project now and could be given (straight away) 3 guarenteed IOUs.
      One for exactly one year from today
      One for exactly two years time
      and one for exactly three years time

    These IOUs are so certain, the bank will lend you money now using them as security that they will be paid.
    How much will the bank lend?
    The bank will lend you as much money as would equate to the value of the IOU when the time comes for it to be paid.

    So if your bank lend to you at 10%pa and your guarenteed payment in one year is £10,000, the bank will lend you £9,090 now knowing that in one year it will be worth that +10% =£10,000.
    This means that the present value value of £10,000 in one year at 10% is £9,090

    And if the second year's guarentee is £10,000 as well, the bank will lend you £8,264 now, knowing that when they have added interest on this will come to £10,000 in two years time.
    This means that the present value of £10,000 in two years at 10% is £8,264

    And if the third year's guarentee is £10,000 as well, the bank will lend you £7,513 now, knowing that when they have added interest on this will come to £10,000 in two years time.
    This means that the present value of £10,000 in three years at 10% is £7,513

    Net Present Value (NPV) links all the present values of the cash flows together.
    If the project costs £20,000 now
    Then the NPV is
      (£20,000)being paid out
      £9,090
      £8,264
      £7,513
      £4,867 would be the NPV

      You can see that the 10% cost of borrowing the money allows the project to show a positive NPV. If the cost of borrowing goes up the NPV will fall. at some point the cost of borrowing will go up so much that the NPV will be 0. At this point we descibe the % rate as the Internal Rate of Return (IRR)

      I hope this adds a little bit.

      If you go on to study this topic at a higher level, you will see that inflation is dealt with in a rather different way, but at this stage use whatever works for you.

      sandy.hood@chichester.ac.uk
    • System
      System Posts: 100,534 🤖 Admin 🤖
      Re:Payback, NPV anf IRR

      Here is a mind map of capital investment appraisal. It includes 2 measures not in the ECR syllabus: profitability index and accounting rate of return.
      But
        NPV
        Payback Period
      and
        IRR
      are definitely in the syllabus
        and you will need to understand cash flows to calculate these measures
      Even for those students who are not primarily visual learners I think it is a useful addition to your notes and as the song says:
      A picture paints a thousand words.
      http://www.bized.ac.uk/educators/16-19/business/accounting/presentation/investment1map.gif

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