The payback period is the ratio of the initial fixed investment over the annual cash flows for the recovery period. If the cash flows are an annuity, the total cost of investment is divided by the annual cash flow to arrive at the payback period. Alternatively, the cash flows can be subtracted from the total cost until the remainder becomes zero and the payback period determined accordingly. So long as the payback period is shorter, the project is considered a better project to invest in. The major shortcoming of the payback period is that it fails to consider cash flows occurring after the payback period.
Internal Rate of Return (IRR)
The IRR method considers the time period during which the cash flows are generated and the volume of such generations through the entire period of the life of the project. The internal rate of return represents the discount rate that is equivalent to the present values of the anticipated cash flows as against the number of investments in the project. The project will be accepted when the internal rate of return is equivalent to or higher than the required rate of return, which is also called the hurdle rate or cutoff rate.
Modified Internal Rate of Return (MIRR)
Another way of arriving at the IRR is denoted by the Modified internal rate of return (MIRR). This method assumes that the cash generated out of a project is re-invested at the cost of the capital of the firm. The cost of capital is usually assumed to be the WACC to the firm. This method is considered preferable to the normal IRR method because (i) any series of cash flows has a MIRR and (ii) the MIRR takes into account the rate at which the cash generated out of the project is re-invested, and to this extent, this method is more scientific than the trial and error method being followed in the IRR method.
Net Present Value (NPV)
The net present value method takes into account the discounted present values of all the cash inflows. The discounting factor is generally the required rate of return for the project. When the total of the present values of the discounted cash flows is zero or greater, the management may take a decision to accept the project. Another way to express the acceptance criterion of the method is to say that the project will be accepted if the present value of the cash flows exceeds the present value of the cash outflows.
The profitability index method, or the benefit/cost ratio as it is otherwise called, the initial investment in the project is compared with the present value of the anticipated cash inflows from the project. When this ratio is more than one, the project is considered to be viable. Because of the similarity in calculations, for any given project, the NPV and profitability index gives the same acceptance/rejection signals. Out of the NPV and IRR methods, the NPV method is preferable since it expresses the economic contributions from the project in absolute terms.
Scenario analysis is a different version of sensitivity analysis. Sensitivity analysis investigates and reports on the changes in the NPV calculation due to variations in the factors assumed for the original calculations of NPV. The objective of scenario analysis is to analyze and report on the variations in the NPV of a project on various possible scenarios. Normally in these scenarios, each one of them involves a number of factors. A series of scenarios, when visualized, will illuminate issues concerning the project better than the standard application of sensitivity analysis.