1. 1 Introduction
2 Summary of Ranking Methods
2.1 The Undiscounted Payback Method
.2.2 The Discounted Payback Period
2.3 Net Present Value (NPV) Technique
2.4 The Internal Rate of Return (IRR) Method
.2.5 Net Future Value (NFV) Technique
3 Example of the Determination of the Discounted
Cash
Flow Selection Criteria for a Project
4 Concluding Remarks

2.  Comparison of mutually exclusive alternatives,
which means analysis of several alternatives
from which only one can be selected (such as
selecting the best way to improve an existing
operation or choosing the best of several to
develop)

3.  Ranking non-mutually exclusive alternatives
which means analysis of several alternatives
from which more than one can be selected
depending on capital or budget restrictions
(such as ranking research or development
projects to determine the best ones to fund
with).

4. The payback period methods, being the number of
years (or time periods) required to return the
original investment. The payback period is
usually determined on an undiscounted basis,
but discounted payback periods must also be
established for a project. (See sections 1.2.1 and
1.2.2)(2)

5. The net present value (NPV) method: being the
present value of future benefits discounted at
the appropriate cost of capital, minus the
present value of the capital cost of the
investment. (See section 1.2.3)

6. The internal rate of return (IRR) method: being
the discount rate which equates the present
value of benefits to the present value of the
capital expenditure. (Section 1.2.4)

7. The net future value (NFV) method: being the
future values of benefits compounded at the
appropriate cost of capital, minus the future
value of the investment cost compounded at
the same cost of capital. (See section 1.2.5)

8.  Assume that two projects are being considered
by a company. Each requires a capital
investment of $10,000. The marginal cost of
capital is 10%. The net cash flows (i.e. net
operating incomes after taxes plus the
depreciation allowance) from the investments
A and B are shown in the following table.

9. Year A B
1 5,500 1,000
2 4,500 2,000
3 2,000 3,000
4 10 4,000
5 10 5,000

10.  The payback period is the number of years it
takes to recover the initial investment from
after tax cash flow profits. It is observed that
project A has a 2 year payback period, whilst
project B has a 4 year payback period. If the
firm employed, say, a two or three payback
period selection criterion, project A would be
accepted, and project B would be rejected.

11.  As flaws in the simple undiscounted payback
method were recognized, people began to
search for methods of evaluating projects that
would recognize the time value of money, and
that would not automatically discriminate
against projects which show their greatest
profitability later on in the future. This
recognition led to the development of
'discounted cash flow' (i.e. DCF) techniques to
take account of the time value of money.

12.  It is important to emphasize that if the
investment capital is expended over a period of
several time periods, rather than as a lump sum
at the beginning of the project, then the
investment amounts for each time period
should also be discounted and summed before
being subtracted from the sum of the
discounted income cash inflows.

13.  The internal rate of return (IRR), sometimes
called the discount cash flow rate of return
(DCFROR) or simply the rate of return (ROR) is
defined as that discount rate found by trial and
error which equates the total present value of
the expected after tax income cash flows (or
benefits), to the total present value of the
capital cost outlays (i.e. both working capital
and fixed capital).

14.  The significance of the internal rate of return is
that if it has a value which is greater than the
marginal cost of capital for the firm, then the
value of the firm will increase. Naturally then,
the project with the highest IRR would be
expected to increase the value of the firm the
most. However, project risk must also be taken
into account when making a final decision.

15.  A real understanding of the use of the ranking
techniques comes only with the actual practical
use of the techniques.
 The selection of project time period and
discounting rate, and the estimation of initial
capital expenditure, as well as incomes and
costs to determine cash flow figures is most
important when undertaking economic
evaluations.
"Garbage in = garbage out"!

16.  It is good practice for technical personnel to liaise
closely with the financial project evaluation
personnel. Better still, technical personnel should
first attempt to undertake their own preliminary
economic evaluations. Then, in the event of the
economic project selection criteria not being
satisfied, the technical personnel can communicate
meaningfully with the financial personnel to find
out the major reasons why the project has not been
acceptable. They can then go back to the process to
try and establish whether opportunities exist to
overcome the economic deficiencies. For example,
leasing of equipment can substantially reduce the
upfront capital requirements.

17.  Although the techniques described in this
section have been applied to the ranking of
multiple mutually exclusive and non-mutually
exclusive projects, many of the techniques can
be used to evaluate the profitability of an
individual project on its own.

18.  n Although not mentioned before, it is important
to appreciate that "sunk costs", or costs incurred in
the past, tend to be irrelevant when considering
economic decisions for the future. One should not
become emotionally attached to projects on which
much time and/or money has already been spent.
If at any time another project arises which can
clearly be shown to be a better investment
opportunity, then it should accordingly be ranked
higher than the sentimental project. It is no good
crying over spilled milk - the past is gone and it is
the future that counts. Do not “throw good money
after bad”.

19.  One should always bear in mind the concept of
“opportunity cost". Thus if an opportunity
exists to undertake a more profitable project,
and a less profitable one of equivalent risk in
fact chosen - an opportunity cost has been
incurred in the sense that the opportunity to
earn more profit has been forfeited. However,
sometimes non-quantitative aspects such as
strategic, health, safety or environmental
considerations could swing the decision in
favor of the less profitable option because of
the gains to be made in other respects.