NPV IRR Payback period scenarios
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- Опубликовано: 30 июл 2024
- Let me help you improve your understanding of Net Present Value, Internal Rate of Return, and the payback method, by running various scenarios and analyzing the impact on NPV, IRR and payback.
Meet our project manager, Jane. She is working on an investment project for her site. Besides working on the technical specifications, she needs to put the numbers together to get approval to move ahead with the project. After working with various suppliers and the Operations Manager, Jane has come up with the following estimates for the “Base Case” of the project. The expected upfront investment is $1000, which is cash out. The expected benefits are $400 per year, for four years, which is cash in. Jane has documented her assumptions, and feels that these estimates are reasonably accurate.
⏱️TIMESTAMPS⏱️
0:00 Investment project assumptions
0:58 NPV IRR payback period explained
2:07 Improving financial attractiveness of a project
3:09 Comparing project alternatives
3:44 NPV IRR payback period vs base case
5:53 NPV IRR payback maximization
Jane inputs her numbers into a spreadsheet that she received from a finance colleague. With a 20% discount rate (or WACC) that is used for investment projects in the company, the project has a Net Present Value (NPV) of $35, an Internal Rate of Return (IRR) of 22% and a payback period of two and a half years. What do these numbers mean? NPV needs to be bigger than zero, which at $35 it is. Internal Rate of Return needs to be higher than the discount rate: 22% for the project is higher than the 20% discount rate. Payback period is 2.5 years. Jane wants to make sure the numbers are calculated correctly, so she checks the Excel formulas for NPV, IRR and payback period, which seem to be working fine. After these verifications, Jane submits her project for approval. She doesn’t get an immediate “yes” or “no”, but hears the words that every project manager dreads: “You can do better than that…”.
Jane is at a loss. What does she do now? There are several ways to improve the financial attractiveness of a project, based on more optimistic assumptions. To make it easy to compare these, each of the improvement ideas is worth $100 on a nominal basis. The first idea, let’s call it A1, is to reduce the spending on the initial investment. Jane changes the scope of the investment without losing functionality and benefits, saving $100. The second idea, A2, is to find additional benefits of $25 per year in each of the four years. Incremental savings that she may have overlooked in the first draft of the project. The third idea, A3, is to extend the benefits: one quarter in year 5. Which of these variations on the original project do you prefer, or are they all equal?
Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better #investing decisions. Philip delivers #financetraining in various formats: RUclips videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!
I have learned more from this channel than other sites and school combined.
Wow, I am honoured to hear that! Please spread the word.
“You can do more/better!” - the best motivating words we hear 😅
Great video, and thank you for the improvement ideas...
Yep! You've heard them, I've heard them. And they seem to encourage "sandbagging" (coming in with a low scenario in the first review).
Always great to learn from ur channel
Thank you very much once again. :-)
Historic!!!!! Need lot more scenarios.
Thank you! Your comment warms my heart. :-)
great vid. thank you!
You're welcome! Thank you for watching.
Awesome! Thank you :)
You're welcome, Timur! Happy to help.
Good stuff. Thank you
You're welcome! Thanks for your support.
In the chapter about capital decision making (or something like that, can't remember correctly), aside these three my textbooks also has the Accounting Rate of Return (ARR) and Profitability Index (PI). Would you please cover those on the channel too?
Thank you for the suggestions, Surya, I had not heard of these terms before (or I did hear about them, and forgot 😉). Apparently, Accounting Rate of Return (ARR) is the same as Return On Investment: ruclips.net/video/o4of1uNSRis/видео.html Profitability Index (PI) is a very interesting one, I will add that to my list of topics for future videos.
Just published my Profitability Index (PI) video: ruclips.net/video/Md5ocNqKHq8/видео.html Hope you like it!
Excellent 🤩🤩🤩
I agree! ;-) Thanks for watching and commenting.
great🙇
Thank you!!! :-)
Very well explained - even I understood the principles. Nevertheless I still have trouble to integrate the NVP and IRR method into my personal stock valuation spreadsheet. Could you eloborate on the NVP and IRR method regarding stock investments in practice?
Hello! Thanks for the kind words. Two ways that I hope I can help you there. First, my video on how to calculate stock returns ruclips.net/video/TYzGGOk-8kE/видео.html Second, within the next few days I will record my video on how to use discounted cash flow (DCF) to value stocks.
@@TheFinanceStoryteller thanks a lot! I’ll definitely have a look :) I am still going through all you’re videos whenever I have spare time. You’re keeping me busy 😂
Take as much time as you need & enjoy the ride. 😊 Here's the link to my playlist with videos on stock market investing, there should be some interesting stuff in there for you: ruclips.net/video/K4mWd2zBYVk/видео.html&pp=gAQBiAQB
Definitely better than my professor's explanation. Could you do a video on MARR please? Is there a possibility for hw help? I'm a physicist taking an engineering class on finance :(
Thanks for the compliments! I hope you will find a lot of useful videos on my channel. I have done a lot of walk-throughs of financial statements that could be of interest to you. I think concepts like Minimum Acceptable Rate of Return (MARR) and Weighted Average Cost of Capital (WACC) are overrated, and they are "overengineered" with partly nonsensical formulas by people that want to make themselves sound important. I do have a video on WACC vs IRR that might help you to understand the context a bit: ruclips.net/video/ZuH_q5crAWg/видео.html
Thanks, I'm currently watching all the videos related to my class. I do agree that this is over-engineered due to the unpredictability of business in general. Modeling the past is easier than the future. I do hope you cover additional topics soon such as present value of an annuity.
You are thinking in the right direction: "unpredictability of business in general"! There is a tendency in economics and finance to look at averages and take out outlier data points from samples to "normalize" them. This is very likely to hurt you when the next unexpected shock occurs (in markets, or life in general). I would recommend reading "Outliers" by Malcolm Gladwell and "The Black Swan" by Nassim Taleb. Taleb keeps repeating that a lot of people have drowned trying to cross a river that is on average four feet deep. ;-) Here's my book review of Taleb's "The Bed of Procrustes" to get you an idea of his works: ruclips.net/video/fUU9sPU__MY/видео.html
Thank you for diverting me here this Dear Sir, in the field of real estate property, our financial business model doesn't use an initial investment when computing for the NPV. The NPV results doesn't get subtracted from the initial investment as my fellow mate will argue that there is technically no initial cashout for the company. So the resulting NPV by that gets the one to be computed for the IRR. Is that ok?
Whatever works for you to compare different opportunities. If you don't take an initial investment into account, then what you are technically doing is calculating present values of future cash flows, not an NPV...
@@TheFinanceStoryteller final question dear Sir, are project costs considered investment or initial investment to be considered in the NPV? I believe if we buy land then that would be our initial investment, but should we develop it into something else, a house or a building, the cost for the can be considered or use as initial investment? or the purchase of land only? Thank you very much by the way, i really really really appreciate your responses and advices. I am sharing your videos to my colleagues.
@@mariomarmolejo2774 Hello again! I don't have experience in the real estate industry, but I would guess that land and building would be part of the investment, and the future benefits would consist of rent payments from third parties. Please note that for accounting purposes, land does not get depreciated, while buildings do.