You reach the final pages of a feasibility study and find three figures heading the executive summary: net present value, internal rate of return and payback period. Many investors simply check whether the figure is positive or negative, or whether the percentage is high, and then decide. But each of these three indicators answers a different question, and each can mislead you if read in isolation. In this article we explain what each one measures and how to read them together to make a sounder decision.
Why "annual profit" alone is not enough, and the role of the discount rate
Accounting profit in the income statement does not answer the investor's real question: is this project worth putting my money into rather than investing it elsewhere? There are two main reasons for this:
- The time value of money: a rial you receive today is worth more than a rial you receive in five years, because you can invest it now and because the future carries risk.
- The difference between profit and cash: depreciation, for example, reduces profit without any cash leaving the project, while repaying the financing principal takes cash out without appearing as an expense in the income statement.
That is why decision indicators are built on cash flows rather than profits, and take their timing into account.
The discount rate: the starting point many overlook
Before any indicator, the discount rate must be set. It is the minimum return you will accept for tying up your money in this project, with its risks. It is usually influenced by three factors:
- The financing cost, if any.
- The return capital owners expect from alternative investments of similar risk.
- The project's specific risk: a new project in an untested sector warrants a higher discount rate than the expansion of an existing business.
Choosing an unjustifiably low discount rate makes any project look feasible, so this assumption must be explicit and justified in the study. Good practice is to present results at more than one discount rate, so readers can see for themselves how the picture changes if their view of the risk differs from that of the study's author.
Net present value (NPV): how much does the project add to your wealth?
Net present value is the sum of future cash flows discounted to their value today, minus the initial investment.
How to read it
- Positive: the project earns a return above the discount rate and adds value equal to this figure.
- Zero: the project earns exactly the required return, no more.
- Negative: the project does not cover the required return, even if it is profitable in accounting terms.
Its strengths and limitations
Its strength is that it measures value in rials, which makes it suitable for choosing between projects competing for the same capital. Its limitations are that it is highly sensitive to the discount rate and to the residual value at the end of the analysis period, and that it does not show the size of the return relative to the investment: a large project may deliver a higher net value with a weaker relative return.
Internal rate of return (IRR): what is the implied annual return?
The internal rate of return is the discount rate that makes net present value equal to zero. Put more simply, it is the compound annual return the project earns on the money invested in it.
How to read it
Compare it with the discount rate or the financing cost. If the IRR is higher than both, the project is acceptable in principle, and the wider the gap, the greater the margin of safety.
When does it mislead you?
- When comparing projects of different sizes: a small project with a high return may add less value than a larger project with a slightly lower return.
- When the sign of the cash flows changes more than once: for instance, if the project needs a large additional investment midway through its life, several rates may appear, or no meaningful rate at all.
- The reinvestment assumption: the indicator implicitly assumes that interim cash flows are reinvested at the same rate, an optimistic assumption when the rate is very high.
Payback period: when do you get your money back?
The payback period is the time needed for cumulative cash flows to cover the initial investment. It is the most intuitive indicator for non-specialists, and it matters especially to investors with limited liquidity and to funders who look at the project's capacity to repay.
Its limitations
- It ignores cash flows after the payback point entirely.
- In its simple form it does not account for the time value of money, which is why it is advisable to calculate the discounted payback period as well.
A hypothetical example for illustration
You have OMR 100,000 and two alternative projects, each with a five-year analysis horizon, and the adopted discount rate is 10%:
| Year | Project (A) | Project (B) |
|---|---|---|
| 0 | -100,000 | -100,000 |
| 1 | 30,000 | 10,000 |
| 2 | 30,000 | 20,000 |
| 3 | 30,000 | 30,000 |
| 4 | 30,000 | 40,000 |
| 5 | 30,000 | 60,000 |
Approximate results:
| Indicator | Project (A) | Project (B) |
|---|---|---|
| Net present value at 10% | About OMR 13,700 | About OMR 12,700 |
| Internal rate of return | About 15.2% | About 13.8% |
| Simple payback period | About 3.3 years | 4 years |
Project (B) generates larger total cash flows (OMR 160,000 versus OMR 150,000), yet Project (A) outperforms it on all three indicators because its cash flows arrive earlier. Now raise the discount rate to 14% because you see the risk as higher: Project (A)'s NPV remains positive at about OMR 3,000, while Project (B)'s turns negative at about OMR 700. This is how changing a single assumption exposes the fragility of a project that seemed acceptable.
How to read the three indicators together
| The question you are asking | The most suitable indicator |
|---|---|
| Does the project add value above the required return? | Net present value |
| What is the margin of safety relative to the financing cost? | Internal rate of return |
| Can I afford to have my money tied up for this long? | Payback period |
| Which project should I choose among alternatives? | Net present value first, then the others |
The practical rule: start with NPV to know whether the project is worthwhile, use IRR to measure the margin, and treat the payback period as a test of your ability to wait and of your liquidity. It is also useful to look at the break-even point, the volume of sales or revenue at which revenue equals costs, because it translates abstract financial indicators into an operational figure the project manager understands day to day: how many customers or units do I need so as not to lose money? Then ask the most important question: how well do these figures hold up if the assumptions change? That is the subject of our article on sensitivity and scenario analysis.
Common mistakes when reading the indicators
- Accepting figures without disclosed assumptions: an indicator is only as good as the assumptions it is built on.
- Overlooking working capital in year one and its recovery at the end of the analysis period.
- An inflated residual value in the final year that accounts for most of the NPV.
- Comparing IRR with returns on investment deposits while ignoring the large difference in risk.
- Neglecting taxes, zakat and recurring costs such as equipment replacement and refurbishment, which inflates net cash flows.
- Confusing project return with owners' return when there is bank financing, as each is calculated differently. Funders usually require additional indicators related to repayment capacity, which we covered in our article on bank financing requirements.
Conclusion
Net present value tells you how much the project adds, the internal rate of return tells you at what return, and the payback period tells you when you get your money back. None of them is sufficient on its own, and all three together are not enough if the assumptions behind them are undocumented or their sensitivity untested. Always ask to see the discount rate and its basis, the source of every key assumption, and the effect of changing it on the results. If you want a transparent financial model that you can review and whose assumptions you can adjust yourself, we are ready to help: request your study.
Frequently asked questions
Which indicator matters more: net present value or internal rate of return?
Net present value is the more accurate reference when choosing between competing projects because it measures the value added in rials. The internal rate of return is useful for a quick comparison with the financing cost, and it is best to read both together alongside the payback period.
How do I choose the right discount rate for my project?
The discount rate reflects the cost of the funds used and the return the investor requires for the project's risk. It is usually built on the cost of bank financing and the required return on equity, and then raised as the risk of the activity or the uncertainty in its assumptions increases.
Does a short payback period mean the project is good?
Not necessarily. It measures only how quickly the invested amount is recovered and looks neither at what comes afterwards nor at the time value of money. A project with a longer payback may therefore be worth more in the long run.
