What are some common pitfalls and errors in NPV and payback period analysis?

1 NPV assumptions and uncertainties

NPV is based on the assumption that future cash flows can be discounted at a constant and appropriate rate, and that the project has no externalities or interactions with other projects. However, these assumptions may not hold true in reality. For example, the discount rate may change over time due to inflation, interest rates, or risk factors. The future cash flows may also be uncertain or volatile due to market conditions, competition, or technological changes. To address these issues, you can use sensitivity analysis, scenario analysis, or Monte Carlo simulation to test how NPV changes with different assumptions and uncertainties.

2 Payback period ignores time value and cash flows

Payback period is the time it takes for a project to recover its initial investment. It is a simple and intuitive measure of liquidity and risk, but it also has some major drawbacks. First, it ignores the time value of money, meaning that it does not account for the opportunity cost of investing in the project. Second, it ignores the cash flows that occur after the payback period, meaning that it does not capture the full profitability of the project. To overcome these limitations, you can use discounted payback period, which applies a discount rate to the cash flows, or combine payback period with NPV or internal rate of return (IRR) to evaluate both liquidity and profitability.

3 NPV and IRR inconsistency

NPV and IRR are two alternative ways of measuring the profitability of a project. NPV is the difference between the present value of cash inflows and outflows, while IRR is the discount rate that makes NPV zero. Ideally, they should give the same ranking of projects, but sometimes they may conflict. This can happen when the projects have different sizes, timings, or signs of cash flows. For example, a project with a large initial outlay and small positive cash flows may have a high IRR but a low NPV, while a project with a small initial outlay and large negative cash flows may have a low IRR but a high NPV. To resolve this inconsistency, you should use NPV as the primary criterion, as it reflects the absolute value added by the project.

4 Payback period and mutually exclusive projects

Payback period is often used as a screening tool to filter out projects that take too long to recover their initial investment. However, this may lead to suboptimal decisions when comparing mutually exclusive projects, which are projects that cannot be undertaken simultaneously. For example, suppose you have two projects with the same initial investment of $100,000, but different cash flows and payback periods. Project A has cash flows of $50,000, $40,000, and $30,000 in the first three years, and a payback period of two years. Project B has cash flows of $20,000, $60,000, and $80,000 in the first three years, and a payback period of three years. Based on payback period alone, you may prefer project A over project B, but this would ignore the fact that project B has higher total cash flows and NPV. To avoid this mistake, you should compare projects based on their incremental cash flows and NPV.

5 NPV and scale problem

NPV is an absolute measure of profitability, meaning that it depends on the size of the project. This may create a scale problem when comparing projects with different initial investments. For example, suppose you have two projects with different initial investments and NPVs. Project C requires an initial investment of $200,000 and has an NPV of $50,000. Project D requires an initial investment of $100,000 and has an NPV of $40,000. Based on NPV alone, you may prefer project C over project D, but this would ignore the fact that project D has a higher return per dollar invested. To solve this problem, you can use profitability index (PI), which is the ratio of NPV to initial investment. Project C has a PI of 0.25, while project D has a PI of 0.4. Based on PI, you would prefer project D over project C.

6 Payback period and cutoff point

Payback period is a relative measure of liquidity and risk, meaning that it depends on the cutoff point or the maximum acceptable payback period. This may create a subjective and arbitrary problem when selecting projects. For example, suppose you have two projects with the same initial investment of $100,000, but different cash flows and payback periods. Project E has cash flows of $40,000, $30,000, $20,000, and $10,000 in the first four years, and a payback period of 2.5 years. Project F has cash flows of $10,000, $20,000, $30,000, and $40,000 in the first four years, and a payback period of 3.5 years. Based on a cutoff point of three years, you may accept project E and reject project F, but this would ignore the fact that project F has higher total cash flows and NPV. To avoid this problem, you should use a cutoff point that reflects the opportunity cost of capital and the risk of the project.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?