3.6  Alternative Decision Guidance Methods

The NPV method is the preferred method for the evaluation of proposals. However, there are mathematical alternatives to NPV analysis for evaluating projects. They may be useful in combination with NPV. If an NPV has already been calculated, it is probable that alternative measures can be easily calculated.

The Internal Rate of Return is a potentially useful alternative measure, particularly where there is a lot of uncertainty about the discount rate. The payback method and benefit-cost ratio are also occasionally applied.

3.6.1  Internal Rate of Return

The Internal Rate of Return (IRR) method is one alternative to the NPV. It can be useful for proposals for which it is very difficult to determine a suitable discount rate. The IRR is the discount rate which would give an NPV of zero, given expected cashflows. Under many typical circumstances the IRR produces sensible results, and may be calculated easily using a spreadsheet package.

=irr(C1:C4)

However, there are cases in which the IRR produces unusual results:

• It may not be possible to find the IRR at all (i.e. there is no discount rate that gives an NPV of zero).
• Mathematically, there may be more than one IRR, and it can be difficult to know which to use.
• The IRR does not distinguish between projects of different sizes. Using IRR as the sole criterion, a project which has an NPV of $1,000 and an IRR of 25% would be considered preferable to a project which has an NPV of $1,000,000 and an IRR of 20%. Assuming the smaller project cannot be replicated many times, the project with the large NPV may well be more desirable, even though it has a lower IRR.
• Various extensions to the IRR method have been developed (modified IRRs). While they improve the measure’s properties, the additional effort required often means it will be more sensible to simply calculate the NPV, which is a conceptually superior measure.

3.6.2  Payback Period

Another alternative to NPV is the Payback Period method. This method determines the point in time at which cumulative net cashflows exceed zero. For a normal project, a large outlay at the beginning of the project is followed by smaller net inflows for several periods, with the cumulative inflows eventually covering the initial outlay and providing some net benefit. The point at which the initial outlay is covered is the payback period.

The payback method has several major weaknesses. Firstly, it does not discount cashflows (although discounting could be added easily to solve this – see example 3.9 below). Secondly, it does not take account of cashflows beyond the payback period, which could be large and affect the desirability of undertaking the project. And thirdly, it is a measure of time, not a measure of value.

3.6.3  Benefit-cost Ratio

A final alternative is the benefit-cost ratio (BC ratio). The BC ratio is given by:

BC = sum of present values of benefits (cash inflows) ÷ sum of present values of costs (cash outflows)

A BC ratio above one implies an NPV greater than zero.

In the case of single cash outflow (occurring in the first period), the benefit-cost ratio is also called the Profitability Index.

The BC ratio is a useful measure because when there are a large number of proposals, there may not be enough resources available to undertake them all, even if they all have high net present values. As a rule of thumb, picking the projects with the highest BC ratios can ensure maximum value for money in terms of contributing to outcomes. BC ratios have regularly been used to choose which of many proposed roading projects to proceed with.[49]