Evaluating Capital Investment Projects From Pome By
Gautam Koppala
Author: GAUTAM KOPPALA
Evaluating Capital Investment Projects
In order to evaluate the capital project, you must relate all of the costs and cash flows of the project into an evaluation model so that
management can judge the attractiveness of the investment. Several methods are used to assess the attractiveness of a project. The
most frequently used are payback period, discounted payback period, net present value, internal rate of return, and the modified internal
rate of return.
Payback Period
Payback period is the time elapsed from the start of the project until the investment dollars have been recovered by the project's cash
inflows. This method of evaluation is very easy to calculate and to understand. As a result many companies use it, even though it does
not address the time value of money and does not take into account any cash flows subsequent to the recovery of the initial investment.
When someone proposes an investment, the first question asked is often, "What's the payback period?"
Though many textbooks suggest that there is no risk assessment in the payback method, in fact, the sooner you recover your investment,
the lower the risk. However, the payback method is really not a good way to evaluate projects, particularly dissimilar ones competing for
limited investment funds.
To compute the payback period, deduct cash flow amounts from the original investment until the entire initial investment has been
recovered. The process is very simple and easy to understand, but as with most things that are simple, payback period leaves out
something important. In this case, it is any consideration of the time value of money. This oversight is addressed through the
determination of the discounted payback period.
Discounted Payback Period
As noted, the payback period calculation does not pay any attention to the impact of time on the value of money received. To remedy this
problem, analysts have developed a process called the discounted payback peri