A combination of payback period, Net Present Value and IRR methods is a suitable way of measuring a project’s appropriateness. By providing a way of picking the most suitable project in consideration of the expected payback time, expected return and cost of capital. (Vinci, 2010) In that respect, the project’s choice is made by considering the three methods evaluation that can be summarized as follows.
Pay back method
The method entails evaluating projects in terms of the number of years that it would take for the invested capital to be paid back. In that respect, the suitable project among the list is the one with the shortest payback period. According to the method, a shorter payback period is an indication of a higher return on capital while a longer payback period denotes a lower return. Further, the method is useful in ranking projects for a business that has liquidity problems hence needs a quick repayment of its investments. However, the method has weaknesses that require it to be used in combination with other techniques like the NPV, IRR and ARR. Among the key weakness is that it ignores money’s time value, it fails to consider other cash flows beyond the capital recovery period a period during which some projects are capable of delivering significant returns, it may fail to qualify projects which have suitable return rate just on the basis of the payback period benchmark. In that respect, although the two projects falls within the benchmark expected payback period, the small wind-farm project ranks as favorable for having a shorter payback period of 6.01 years as compared to the larger project which has 6.21 years. (Dayananda, 2002)
Net Present Value (NPV) Method
After identification of the suitable project in terms of the payback period which is suitable in application as the screening model, NPV method which uses discounted cash flows considering time and risk variables of an investment is then applied. (Bodie, Kane & Marcus, 2008) The method discounts the cash flows expected from a project with application of the businesses cost of capital and the projects’ life span. In that respect, projects with positive net present value are deemed suitable while those with negative value are unsuitable. Thus, although both projects are acceptable for having positive NPV values, the large wind-farm project is favorable for having a large NPV value of £45,281 compared to the small wind-farm project’s NPV of £26,383. (Dayananda, 2002)
Internal rate of return evaluation method (IRR) provides a discount rate with which a projects’ net present value equals zero hence equating the projects value with the initial cash outlay. In that respect, a project is suitable if its IRR is greater than the targeted rate of return hence the higher the IRR value the more suitable a project is. Therefore, the method evaluates both projects as suitable for having IRR rates of 26.6% and 24.7% for small and large projects respectively which are higher...