Performance Operations: Grahame Steven Offers His Guide to the Development of Four Key Investment Appraisal Methods-And Their Strengths and Weaknesses

Article excerpt

Research suggests that companies in the late 19th century didn't do comprehensive investment appraisals, although some used the payback technique--along with gut feeling--to decide which projects to pursue. Payback, the simplest appraisal method, works out how long it will take a project to recoup the investment, but doesn't account for cash flows occurring after that time. As a result, its users may still choose unprofitable projects or those yielding low returns.

Table 1 concerns an oil production project with a cash outflow at the end of its life. The cash flow in year five is negative, since it includes the cost of decommissioning the oil rig. To estimate the payback period, we divide the last cumulative cash outflow, which occurs at the end of year two ([pounds sterling]55m), by the cash inflow expected in year three ([pounds sterling]60m). We then add this figure (0.92) to the number of years (two) associated with the last negative cumulative cash flow to obtain the project's payback period: 2.92 years. This approach assumes that cash flows occur equally throughout a year. In practice, of course, they may vary according to the seasonal nature of the business.

1 Oil project payback calculation

Year  Annual cash flow                        Cumulative cash flow

0                     -[pounds sterling]125m  -[pounds sterling]125m
1                       [pounds sterling]20m  -[pounds sterling]105m
2                       [pounds sterling]50m  -[pounds sterling]55m
3                       [pounds sterling]60m   [pounds sterling]5m
4                       [pounds sterling]40m   [pounds sterling]45m
5                      -[pounds sterling]15m   [pounds sterling]30m

Payback: 2.92 years

[ILLUSTRATION OMITTED]

Payback cannot evaluate mutually exclusive projects because it doesn't consider the whole project period--would it be better to accept a project with a longer payback period that provides higher returns after that point than to accept a project with a shorter payback period but lower returns?

Table 2 considers two mutually exclusive projects with different cash flow profiles. If we were to use payback to choose between them, we'd pick project A for its shorter payback period. But would this be the right decision? While payback does not calculate a return for a project, it does provide a simple measure of risk. Most people intuitively feel that the longer the payback period, the greater the risk. But the use of payback for investment appraisal was to be challenged by the emergence of new business models that required different management practices.

2 Comparing two mutually exclusive projects using payback

Project A
Year                 Annual cash flow       Cumulative cash flow

0                    -[pounds sterling]25m  -[pounds sterling]25m
1                     [pounds sterling]16m  -[pounds sterling]9m
2                     [pounds sterling]12m   [pounds sterling]3m
3                     [pounds sterling]10m   [pounds sterling]13m
4                      [pounds sterling]8m   [pounds sterling]21m
5                      [pounds sterling]6m   [pounds sterling]27m

Payback: 1.75 years

Project B

Year       Annual cash flow       Cumulative cash flow

        0  -[pounds sterling]35m  -[pounds sterling]35m
        1   [pounds sterling]10m  -[pounds sterling]25m
        2   [pounds sterling]15m  -[pounds sterling]10m
        3   [pounds sterling]20m   [pounds sterling]10m
        4   [pounds sterling]15m   [pounds sterling]25m
        5   [pounds sterling]10m   [pounds sterling]35m

Payback: 2.50 years

The DuPont chemical company was created when two cousins bought their family's interests in a number of firms at the turn of the 20th century. The new organisation was more complex than most of its contemporaries, as it sold many different products to different markets. Its managers realised that they needed mechanisms to evaluate the company's diverse interests and allocate money for investment. …