Investment Appraisal Part2

ACCA P5 Advance Performance Management

Discounted Payback period: Discounted payback period addresses major problem of Payback Period (i.e. ignoring time value of money). In discount payback period cash inflows are discounted to present value using appropriate discount rate and then payback period is calculated.

Drawback of Discounted Payback period

Is the discount rate is relevant (it may change over the life of project)

It still ignores cash flow after full recovery of inputs

Myopic in nature

Internal Rate of Return (IRR): IRR simply says for your investment on a project it will give you a return of X% over the life of the project. (i.e. by the end of project you will receive $x for every $100 of investment) Unlike NPV which is an absolute measure IRR is relative measure. It is the discount rate for which NPV of a project is 0. For project appraisal IRR is compared with cost of capital. Projects with IRR greater then cost of capital is acceptable.

Drawback of IRR

Possible to get multiple IRR – where positive cash flows are followed by negative cash flows

Can’t be used for mutually exclusive projects

Can’t be used to compare projects with different life period

Modified Internal Rate of Return (MIRR): MIRR eliminates possibility of getting multiple IRR. It represents actual return generated by the project considering the earning in the earlier period reinvested at cost of capital. MIRR calculation is carried out in two easy steps. First, all cash inflows are converted to single cash inflow at end of the project assuming that cash flows are reinvested at cost of capital. Then rate of return is calculated which equates to present value of outflow to single cash inflow at the end of project.

Drawback of Modified-Internal Rate of Return

Can’t be used for mutually exclusive projects

Can’t be used to compare projects with different life period