Back to: Financial Management
Hello, class!
I hope you’ve revised our last topic on the time value of money because it will form the basis of what we’re about to learn.
Today, we’re exploring investment decision tools, specifically the Payback Period and Net Present Value (NPV). These are tools that financial managers use to decide which projects to invest in.
Lesson Objectives:
By the end of this lesson, students should be able to:
Define investment decision tools and their purpose.
Explain the concept of Payback Period.
Explain the concept of Net Present Value (NPV).
Apply basic calculations for Payback and NPV.
Discuss the advantages and limitations of each method.
What Are Investment Decision Tools?
Investment decision tools are techniques used to evaluate the potential profitability or desirability of an investment or project. The aim is to allocate resources wisely for maximum return.
1. Payback Period (PBP)
Definition:
The Payback Period is the time it takes for an investment to recover its initial cost from the cash inflows it generates.
Formula (for even cash flows):
Payback Period = Initial Investment ÷ Annual Cash Inflow
Example:
If a project costs ₦50,000 and generates ₦10,000 annually, the payback period is:
₦50,000 ÷ ₦10,000 = 5 years
Advantages:
Simple and easy to calculate.
Useful for assessing liquidity.
Helps in risk assessment.
Disadvantages:
Ignores time value of money.
Ignores cash flows after payback.
Doesn’t measure profitability.
2. Net Present Value (NPV)
NPV is the difference between the present value of cash inflows and the present value of cash outflows. It shows the net gain or loss from a project, considering the time value of money.
Formula:
NPV = ∑ [Cash Inflow ÷ (1 + r)ⁿ] – Initial Investment
Example:
Initial Investment = ₦40,000
Annual Cash Inflow = ₦15,000 for 3 years
Discount rate = 10%
You would calculate the present value of each year’s inflow and subtract the investment.
Advantages:
Considers time value of money.
Considers all cash flows.
Indicates actual value creation.
Disadvantages:
More complex to compute.
Requires accurate estimate of discount rate.
Summary:
Investment decision tools help financial managers select projects that add value to the business. While Payback is quick and simple, NPV is more comprehensive and accounts for time and value. A wise manager knows when to use each.
Class Activity / Discussion:
Class Exercise:
Calculate the payback period for a project that costs ₦20,000 and returns ₦5,000 annually.
Then calculate NPV using a 10% discount rate (let students use simplified tables or calculators).
Evaluation (Assessment Questions):
What is the Payback Period and how is it calculated?
Why is Net Present Value considered better than Payback Period?
State two advantages and two limitations of the NPV method.
A project costs ₦30,000 and returns ₦10,000 annually for 4 years. What is the payback period?
What does a positive NPV indicate about a project?