Payback Period vs Net Present Value - Why You Need Both

Written by: Richard Frykberg

Capital project evaluation plays a crucial role in the success and growth of organizations. It involves assessing the financial viability of a potential investment project to make informed investment decisions. While various financial metrics are available for this purpose, relying on a single metric can be limiting and may not provide a comprehensive evaluation.

In this article, we will explore the limitations of single financial metrics, such as the Payback Period, and emphasize the significance of using reliable financial metrics like Net Present Value (NPV) and Internal Rate of Return (IRR). We will also discuss the importance of considering non-financial dimensions and the challenges associated with spreadsheet-based financial analyses.

Ultimately, we will highlight the importance of reliable financial metrics in capital project evaluation and introduce Stratex Online, a capital budgeting software, that can enhance the evaluation and selection process.

The Limitations of Single Financial Metrics in Capital Project Evaluation

Capital project evaluation is a complex process that requires a multifaceted approach. Relying solely on a single financial metric can lead to incomplete assessments and potentially skewed investment decisions.  When comparing capital projects, the two most common metrics considered are Payback Period and Net Present Value (NPV).

Both measures are useful, but neither is sufficient alone. Let’s delve into the limitations of some commonly used financial metrics.

What is the Payback Period?

The Payback Period is a metric that calculates the time required for an investment to recover its initial cost. Payback Period can be based on either accounting returns (after depreciation) or direct cash flows. Payback Period can be calculated on a nominal or discounted basis.

Payback Period does provide a basic assessment of liquidity and risk by focusing on the breakeven point-in-time. However, the Payback Period equation does not consider cash flows that occur after the breakeven point, potentially leading to a biased evaluation.

Payback Period does provide a simple and intuitive approach to assessing the relative risk profiles of alternative projects. All else being equal, the project with the fastest Payback Period would represent the lowest risk and therefore be more desirable.

The primary limitation of the Payback Period method is that it simply measures time for a project to breakeven — the quantum of value produced is not measured. Clearly it would be nonsensical for a project that returned $100k after 2 years to be preferred over another that returned $1.5m after 2.5 years.

When using Payback Period, it is important to at least calculate the Payback Period on a cash flow basis, and discount future cash flow based on an appropriate discount rate. Whatever your preference (nominal or discounted, accounting or cash flow), Stratex Online will calculate Payback Period consistently for all initiatives.

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Net Present Value (NPV)

Net Present Value (NPV) is a robust financial metric that addresses the limitations of Payback Period. It takes into account the time value of money by discounting future cash flows to their present value. NPV offers a comprehensive analysis of profitability by considering all cash inflows and outflows over the project’s life. This allows for a fair comparison of projects with different time horizons and risks. A positive NPV indicates that the project is expected to generate more value than its cost, making it a viable investment.

When predicting future cash flow, especially for projects involving new technologies or products, there is inherent uncertainty. To address this, a discount rate is applied, which combines a risk-free rate with a risk premium.

The discount rate reflects the required rate of return for projects with similar risk profiles. If the project aligns with an organization’s usual activities, its own weighted average cost of capital can be used as the discount rate. However, if the project is different in nature, such as an automotive company transitioning to electric vehicles, the weighted average cost of capital specific to that industry should be utilized.

It is important to note that even small variations in the discount rate used in NPV calculation can have a significant impact on the calculation.  In periods of high inflation, for example, discount rates are adjusted to reflect the higher required rate of return. Consequently, projects with long-term returns that previously showed a positive NPV may no longer be feasible under a higher discount rate.

One aspect to consider is that while NPV provides insights into a project’s financial viability and profitability, it does not directly reflect capital efficiency. In practice, organizations face constraints in terms of both time and available funds. Therefore, it becomes essential to evaluate projects not only based on their NPV but also the required investment. For instance, a project that delivers an NPV of $1 million from an investment of $2 million is considered more capital-efficient than an alternative project that yields the same return but requires an investment of $5 million.

Overall, NPV is a powerful financial metric that overcomes the limitations of the Payback Period. It accounts for the time value of money and provides a comprehensive analysis of profitability. However, it is crucial to carefully estimate future cash flows, choose an appropriate discount rate, and consider the capital efficiency of a project alongside its NPV when making investment decisions.

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a financial metric used in capital project evaluation that is an effective measure of relative capital efficiency. IRR represents the break-even discount rate for a project. Projects with an internal rate of return greater than the discount rate will produce a positive NPV, and projects with an IRR lower than the discount rate will have a negative NPV.

For this reason, many organizations define a hurdle IRR rate (similar to their discount rate) which projects have to achieve to be included in a capital portfolio. Projects with higher IRRs are generally considered more attractive, as they offer higher returns on the capital invested. IRR provides an indication of the project’s expected return on investment and is a good theoretical measure of capital efficiency.

One of the limitations of IRR is that it assumes cash flows generated by the project will be reinvested at the project’s rate of return, which may not be realistic in practice. This assumption can lead to potential distortions in the evaluation process. Additionally, IRR calculations can have multiple solutions or no particular IRR solution, making interpretation and comparison challenging.

While IRR is an intuitive measure for many executives and can help guide the allocation of constrained funds to projects with faster returns, it is important to consider its limitations. IRR is a relative measure that focuses on the rate of return but does not directly address the overall quantum of value produced by the project. This can be problematic because projects not only consume capital but also significant time and internal business resources, and introduce additional risks.

Therefore, solely relying on IRR as the primary criterion for project evaluation may not capture the full picture of a project’s value and feasibility. Evaluating projects based on IRR alone may lead to a portfolio consisting of numerous small projects with high IRRs but relatively low absolute value returns. In contrast, an alternative project portfolio with slightly lower IRRs but higher absolute value outcomes may be more practically effective and less risky.

To overcome these limitations, it is essential to consider other financial metrics such as NPV and Payback Period, alongside qualitative factors, when evaluating capital projects. NPV provides a comprehensive analysis of profitability, considering the time value of money, while the Payback Period offers insights into the project’s breakeven point and liquidity. By considering a range of financial metrics and weighing them against non-financial factors, organizations can make more informed investment decisions that align with their strategic objectives and risk appetite.

Considering Non-Financial Dimensions in Capital Project Evaluation

When evaluating capital projects, it is important to acknowledge that financial metrics alone do not capture all the factors that influence decision-making. Executives involved in capital budgeting must consider additional non-financial dimensions to rank and prioritize projects effectively. While financial metrics focus on measuring financial outcomes, there are strategic and risk-related considerations that play a crucial role in the decision-making process.

Strategic Alignment: Ensuring Long-Term Success

Assessing strategic alignment involves evaluating how well a project aligns with the organization’s goals, objectives, and long-term strategy. While certain projects may not exhibit strong financial returns, they could be essential for an organization’s long-term success.

For example, many organizations are investing in technologies to reduce carbon emissions and address the risks associated with climate change. Such projects may not have immediate financial gains, but they align with strategic goals related to sustainability and social responsibility. Similarly, organizations that prioritize environmental, social, and governance objectives alongside financial returns should incorporate these factors into their project evaluations.

Capital Project Risk: Evaluating both Risk of Inaction and Implementation Risk

In addition to strategic alignment, executives need to carefully assess the risks associated with capital projects. This involves considering both the risks of implementing the project (implementation risk) and the risks of not pursuing the project (urgency).

While some aspects of risk may be reflected in the selection of discount rates for financial analysis, it is crucial to explicitly evaluate these risk dimensions during project evaluation. By conducting a comprehensive risk assessment, executives can better understand the potential investment opportunity, challenges, and uncertainties associated with a project. This evaluation enables them to balance the risk-reward trade-offs and make informed decisions about project selection.

Challenges with Spreadsheet-Based Financial Analyses

Many organizations still rely on spreadsheet-based financial analyses for capital project evaluation. While spreadsheets offer flexibility and familiarity, they come with inherent challenges that can compromise the reliability of financial evaluations.

Spreadsheet Formula Errors

Spreadsheet financial models are nearly ubiquitous in providing the basis for project evaluation, yet spreadsheets are inherently fraught with error. While the beauty of spreadsheets is their freeform nature, that too is their achilles heel.

Although most Excel-based business case templates start off OK, it is only a question of time before the formulae contained therein become corrupted. Someone inserts a row or column without extending the formula. As much as organizations try and lockdown their templates, they ultimately get distorted to serve the needs of unique project evaluation, and then evolve into wild and exotic monsters with each copy and tweak. Until one day a poor decision will be made, and the root cause traced to an innocent formula error.

Inconsistency of Discount Rates and Assumptions

Even when the formulae are right, inconsistency in formula parameters can have a severe impact on the quality of results produced. Where every project is justified on its own spreadsheet-based financial model to produce nominally comparable financial metrics, how can management be confident that the same assumptions are being consistently applied?

Current market turbulence emanating from the pandemic, war, and climate change and accelerating technological change is impacting inflation, growth and exchange rate assumptions continuously. How quickly and consistently are these global assumptions being factored into the business cases for candidate projects to ensure fair and effective project evaluation and portfolio selection?

Over Simplified Financial Analysis Templates

To aid their effective usage and broad adoption, business case templates are often overly simplified. For example, many financial analysis templates assume a cash outflow in one period, and focus exclusively on the benefit inflows.

In reality project costs combine capex and opex items that are incurred over extended durations and employ varying procurement methods, including leases. Benefits may start to flow sooner than the conclusion of the project as phases are completed.

The inherent problem of a spreadsheet format is that it is difficult to expose additional complexity only when required, and providing all the sophistication that may be required over-complicates the user experience for the many straight-forward projects. Unfortunately, it is the few large, complex, and strategically imperative projects that are the most critical to assess and prioritize carefully.

Spurious Accuracy and the Lack of Sensitivity Analysis

Predicting the future accurately is virtually impossible as there are simply too many variables to consider, many of which will be outside the organization’s ability to control. Financial analyses must therefore be produced based on validated assumptions, and a healthy dose of educated guesswork.

When asked to estimate the return on investment in a capital project, sponsors will typically respond that “it depends”. A few key variables can dramatically affect the outcomes. It depends on input costs, the schedule, and the quality of project execution. It depends on market acceptance, and competitor responses. It depends on the macro-economic environment. All these factors must be identified, and considered, and still a most-likely estimate produced.

This most-likely estimate is then subjected to a range of financial modeling and discounting techniques that imply a degree of accuracy in the presentation of final metrics that may, in fact, be misleading. For example, Project A may produce a Payback Period of 2.2 years vs Project B which has a Payback Period of 2.8 years. Obviously, we should do project A if we only have time and money for one. But how reliable were the estimates used to produce the financial metric?

It may be that project B return was assessable with a high degree of confidence as we have done many like that before. Project A by contrast, may be something entirely new. Checking with the project sponsor may reveal a different perspective if we pose the question “what is the most likely range of outcomes of each of the key assumptions?” This is in practice easier, and a lot less stressful, to provide.

Statistical methods and simulations can then be applied to the project financial analysis, and a most likely, best and worst case outcome projected. Armed with this information, the decision may be less clear-cut.

In our example, Project A may produce a NPV of between -$0 and $2m with a most likely return of $1m. Project B, on the other hand, is likely to produce an expected NPV of between $0.6m and $1m, with a most likely return of $0.8m. Given this additional information and range of outcomes, most risk-averse management teams will then select Project B. Unfortunately, it is very difficult to perform these simulations in an excel model of an individual project, and virtually impossible to do across the entire project portfolio.

Lack of Validation and Review

An often-proclaimed virtue of spreadsheet-based financial analyses is that they are flexible and can be readily adapted to the needs of the specific project. Whilst there is some validity to this argument, the flip-side of this assertion is that tailored spreadsheets are notoriously hard to review and validate. Either a central team invests significant effort to validate the content, integrity and quality of individual submissions, or management accept the purported returns on trust. And with a high degree of misgiving and stress.

A more systemized approach to financial analysis preparation and calculation may forfeit a degree of flexibility, but the ease of consistent validation and review, and the greater effectiveness and confidence that this provides management when making critical project selection determinations should not be underestimated.

The Importance of Reliable Financial Metrics in Capital Project Evaluation and Selection

Reliable financial metrics — such as NPV, IRR, and Payback Period — are of paramount importance in capital project evaluation and selection. By incorporating these metrics alongside a comprehensive assessment of non-financial dimensions, organizations can make better-informed investment decisions. Reliable financial metrics allow for accurate comparisons between projects, account for the time value of money, and provide a holistic view of profitability and risk.

The quality and consistency of calculated measures is essential if valid judgements are to be formed. In addition to financial metrics, most organizations will also need to assess strategic alignment, urgency, and the implementation risk of candidate projects to fully assess the relative merit of competing projects.

To mitigate the risk of invalid project ranking and selection, spreadsheet-based business case models should be avoided. Erroneous formulae, inconsistent parameters, simplified cost assumptions and spurious accuracy are inherent when business cases rely on manually prepared spreadsheet models that are inherently difficult to audit and review.

Stratex Online provides a solution to preparing reliable business cases based on consistent financial analyses and a complete scoring and ranking approach that factors in additional capital project evaluation dimensions. Structured financial analysis templates together with a centralized data source and collaborative digital workflows helps ensure the reliability of presented figures. With Stratex Online, executives can make more confident capital allocation decisions to maximize the return on invested capital and achieve strategic objectives sooner.