Payback: Does it truly pay off?

 

“Disappointment will come when your effort does not give you the expected return”

– Chetan Bhagat

In the previous post, We spoke about how crucial it is to properly conduct the Initiating process before approving any project proposal. Any project is the product of the Company's ambition to meet its requirements for ongoing sustenance, expansion, and growth. As a result, the Company invests a large sum in the project in order to reap the rewards. The business requirements for which the project was undertaken are satisfied once the project's deliverables have been completed. As a result, the new business will begin financially repaying the corporation with increased revenues, profits, etc. The corporation will continue to reap the rewards every year, and eventually the profits will outweigh the overall investment made in the project. If the project covers its whole cost in five years, the subsequent returns are free, allowing the business to continue reaping the rewards without having to invest more resources.  Any successful project completely pays back the initial investment in a very short period.

 Every project, as we are aware, results from a business necessity or challenge. There may be more than one approach to solving the problem, or more than one strategy to address the business challenge. Therefore, the Sponsor will attempt to select the option that returns the company's investment in the shortest amount of time. This is done in the initiating process, wherein all the business alternatives and their payback period are thoroughly studied. (The payback period in years is calculated by dividing the total capital investment by the total annual returns). The alternative that pays back the company in the shortest time is considered for the next Planning stage.  If alternative A gives a payback in 7 years, B in 9 years and C in 5.5 years, the alternative C is chosen.

Here comes the interesting issue. What can be the maximum period of payback? If the alternative that gives the shortest payback time, works out a payback period is 15 years, is it acceptable? The machinery or equipment that would be installed as a result of the project may require a major overhauling due to wear and tear, periodically. If this happens before the payback period, is it acceptable? The project's funding may have come from a bank loan, which would put a financial strain on the business because of the yearly interest payments. Where does the Payback calculation take this interest on capital into account?

The Payback period technique does not provide answers to the aforementioned queries. Therefore, the Sponsor will not be able to choose a project based solely on the payback term. After taking into account the concerns in the preceding paragraph, this must be reinforced with another approach to determine whether the project genuinely generates returns or not.

All of the concerns raised can be resolved using the NPV, or net present value, technique. Let's first grasp what the word "opportunity cost" means before talking about the NPV idea. Why does that matter?

Consider a situation where a business wishes to invest in a project to grow. The business anticipates a 12% return on the capital invested as a result of the expansion after the project is finished. Suppose if the company had not invested on the project and instead deposited the funds in the bank, the returns due to the interest would be 7%. So, by doing nothing and simply depositing the funds, the Company will get 7% returns. This is the opportunity cost. The returns would be 12%, or 5% higher than the opportunity cost, if the company chose to spend the money in the project. Any Company would undertake projects only if it foresees a return that is more than the Opportunity cost. Discounted cash flow is another name for this opportunity cost. The value of the funds spent on the project is represented by the opportunity cost. Money is not free, in other terms. The Payback method of project selection does not take into account this financial value, but NPV does.

NPV considers the future returns of the project at the present market value. To comprehend this idea using a straightforward illustration, If you can get a dosa in a restaurant today for 70.00 INR, you won't be able to do so in two years with the same amount. Inflation would have raised the price of Dosa. After two years, you are forced to settle for a couple of idlis at the same price of 70.00 INR. Therefore, over time, the value of 70.00 INR has reduced. If you wait another five years, you might only be able to afford a coffee. Similar to this, future returns on a project won't be worth the same as they are right now. In other words, if the enterprise generates a $100,000 return after a year, its worth will be lower than it is now. With $100,000 today, you can buy more things than you can in a year, means, the returns are discounted. (Discounted at what rate? For calculation purposes, it is taken at the bank interest rate).

NPV considers the returns after discounting them to arrive at the Present value and portrays a clear picture, whether to go in for the Project or not. The formula is given below.

PV= FV/(1+R)ⁿ                     

Where, PV = present value

FV = Future value

R = Rate of interest

N = no. of years

 

Even while the formula may appear to be complicated, it is actually quite simple if you work it the opposite way around.

 FV = PV*(1+R)ⁿ

 Where, FV = Future value

PV = present value

R = Rate of interest

N = no. of years

 

Now, you would have found out that this is the same formula which is used to find out the amount after applying Compound interest.

 

I'll provide an example to more clearly illustrate the NPV.

The General Manager of a telecom business is approached by a group of residents from a residential colony who ask him to set up a new telephone exchange in their area. For ten years, they seek access to the internet via a broadband facility. Their employer would provide this facility as a fringe benefit, up to Rs. 500.00 per month, in accordance with their employment terms.

 The General Manager asks the people below him to assess the financial viability and receives the following data in a month’s time.

 Capital Cost for starting the new Telephone Exchange = Rs. 50,00,000/-

Rate of interest of Capital = 8%

No. of residents who take the Broadband connection = 100

Telephone bill per month = Rs. 500.00 per connection

Returns per month = 100*500= Rs. 50000/-

Returns per year = 50000*12= 600000

Simple payback period = 5000000/600000= 8.33 years.

Now let us calculate the NPV.

 

 According to the above table, a 50 lakh investment would yield 40.26 lakhs in returns after ten years. To put it another way, the total sum that they will receive in the future is 600,000 * 10 years = 6,000,000, with a value of only 4,026,049 in the present. The graphic below shows how the return degrades with time.

The total present value must be subtracted from the initial investment to determine the net present value, and the outcome must be positive for financial viability.

i.e. NPV = Total PV - investment 

In our example, NPV = Total PV (4026049) – investment (5000000) = (-) 973951.00

NPV is negative. So, the project is not financially viable.

It is interesting to note that the project returns the initial capital in 8.33 years as per the Simple Payback period. But it is found financially not viable since its present value of future returns is less than its investment capital.

The General Manager rejected the Project proposal.

The residents then met with their employer and asked for permission to assign a vacant space in their nearby warehouse for the new telephone exchange on a rent-free basis, which was granted. They approached the General Manager of the Telecom business once again. Since no capital is needed for the building's construction, the capital cost has now decreased to 38,00,000.

 Now, the NPV (–) business capital works out to a positive figure of Rs. 226049.00

The Project was given a thumbs up.

Use the Net Present Value approach to always supplement the payback period. Otherwise, if Payback doesn't actually pay back, you will be disappointed.

 

See you in the next post, bye.