# Payback Period IRR ROI NPV Analysis

Payback Period IRR ROI NPV Analysis

Q2. Investment Options
2.1
Payback period of R&D
Year Net Cash Inflows Ending Uncovered
Investment
0 (300,000) (300,000)
1 50,000 (250,000)
2 100,000 150,000
3 100,000 50,000
4 125,000
5 125,000
6 50,000
Payback period 3 + 50,000/125,000 = 3.4 years
Payback Period for Expansion on Kids Market
Total sneakers market in 2023 is 50,000 pairs, but Ecosneak thinks it can capture 10% of the
market in 2024. So, they will sell 50,000 x 10% = 5,000 pairs.
They will sell 5,000 pairs at a profit of €10 therefore they will make a profit of 5,000 x 10 =
£50,000.
However, the overall kids’ market will grow by 5% per year over the six-year planning
period, so we need to add 5% each year.
Year 1 – 50,000 + (50,000 x 5%) = 50,000 + 2,500 = 52,500
Year 2 – 52,500 + (52,500 x 5%) = 52,500 + 2,625 = 55,125
Year 3 – 55,125 + (55,125 x 5%) = 55,125 + 2,756.25 = 57,881.25
Year 4 – 57,881.25 + (57,881.25 x 5%) = 57,881.25 + 2,894.06 = 60,775.31
Year 5 – 60,775.31 + (60,775.31 x 5%) = 60,775.31 + 3,038.77 = 63,814.08
Year 6 – 63,814.08 + (63,814.08 x 5%) =63,814.08 + 3,190.70 = 67,004.78
Year Net Cash Inflows Ending Uncovered
Investment
0 (170,000) (170,000)
1 52,250 117,750
2 55,125 62,625
3 57,881.25 4,743.75
4 60,775.31
5 63,814.08
6 67,004.78
Payback period 3 + 4,743.75/60,775.31= 3.08 years
The payback method is a simple to use approach that favours projects that produce
substantial cash flows early on. This is beneficial because early cash flows boost a company’s
liquidity while reducing the likelihood of future issues. This technique, however, overlooks
cash flows occurring after the payback period (Oakshott, 2020). For instance, large cash
flows are generated in years 4 and 5 with the option of investing in R&D but are not
considered in the payback approach. Also, even though the payback technique considers the
timing of project expenses and benefits, it is not interested in maximising the profit of the
business owners (Atrill and McLaney, 2019).
2.2
R&D 8%
Expansion into the kids’ market 9%
NPV for R&D investment
Year Net Cash Inflows Discount Factor 8% Present Value
0 (300,000) 1 (300,000)
1 50,000 0.926 46,300
2 100,000 0.857 85,700
3 100,000 0.794 79,400
4 125,000 0.735 91,875
5 125,000 0.681 85,125
6 50,000 0.630 31,500
NVP= 119,900
NPV for Expansion into the kids’ market
Year Net Cash Inflows Discount Factor 9% Present Value
0 (170,000) 1 (170,000)
1 52,500 0.917 48,142.5
2 55,125 0.842 46,415.25
3 57,881.25 0.772 44,684.32
4 60,775.31 0.708 43,028.92
5 63,814.08 0.650 41,479.15
6 67,004.78 0.596 39,934.85
NVP= 93,684.99
According to the NPV expanding into the kids’ market will result in a smaller profit than
investing in R&D and hence investing in R&D will be the most profitable one.
2.3
An investment’s internal rate of return (IRR) is the discount rate that when applied to its
predicted cash flows yields an NPV of zero (Atrill and McLaney, 2019). In most cases, IRR
cannot be determined directly. Iteration (trial and error) is the most common method used.
When discounting at 8%, the NVP for the R&D investment is positive, implying that the
project’s rate of return is greater than 8%. Therefore, increasing the discount rate in theory
will reduce the NPV because the discounted figure decreases as the discount rate rises.
Lets try discount rate of 20%
Year Net Cash Inflows Discount Factor
20%
Present Value
0 (300,000) 1 (300,000)
1 50,000 0.833 41,650
2 100,000 0.694 69,400
3 100,000 0.579 57,900
4 125,000 0.482 60,250
5 125,000 0.402 50,250
6 50,000 0.335 16,750
NVP= (3,800)
IRR = r1 + [NPV1/ NPV1 – NPV2] x (r2-r1) = 8 + [119,900/ 119,900 + 3,800] x (20 – 8) =
= 8 + (0.97 x 12) = 8 + 11.64 = 19.64%
2.4
This report is written with a view to helping Ecosneak’s management to reach a decision
on the best investment option. First, the payback period for both options is calculated. The
payback method identifies when the net cash flow becomes positive (Wisniewski and Shafti,
2019). The option of investing in R&D has a payback period of 3.4 years while the option of
expanding into the kids’ market has a payback period of 3.08 years. The two options have
little difference between them however, expanding into the kids’ market should be favoured
since it has a shorter payback period, which means it will pay back the initial investment in a
shorter amount of time. The payback period method, however, has some clear drawbacks. It
does not consider the overall project’s profitability and cash flows once the payback period
has ended. Therefore, investing in R&D given that the difference in the payback period of the
two options is not significant is a better option if the company cares about its profitability
since, the cash flows after the payback period are greater than those of the second option.
The second method used to assess the two options is the NPV to examine their present
values. Investing in R&D has an NPV of €119,900 while expansion into the kids’ market
option has an NPV of €93,684.99. As a result, the R&D investment will be recommended
because it provides a higher NPV. Finally, the third investment method calculated is IRR,
which refers to the discount rate for a project that will result in an NPV of zero (Wisniewski
and Shafti, 2019). Considering the R&D investment option, it has a positive NPV at a 9%
rate so, the NPV will decrease if this rate rises. If a rate of 20% is selected an NPV of -3,800
will be obtained. After, using the formula, option A’s NPV value would be zero if the
discount rate was 19.64%. Hence, investing in the R&D option will have a positive NPV if
the real-world discount rate is less than the IRR. So, in case Ecosneak’s management is
confident that the discount rate will not increase more than 19.64% over the project’s
lifecycle, its NPV will remain positive. As a result, from the information given above the
option to invest in R&D should be preferred.