Better than payback
David Greenfield, Editorial Director -- Control Engineering, 10/1/2003
In the August 2003 issue, I discussed why it was so important for engineers to start "looking at things like an accountant." My point was that engineers today can no longer satisfy management by ensuring that their decisions are keeping operations running. Today, engineers have to do that and "show the money" to upper management to gain support for their projects. Unfortunately, engineers may not quantify project benefits in the metrics of business and accounting that would be most helpful to their cause.
Here's a review on how to "find" the money to support buying decisions and project needs.
To justify the value of your purchasing decision, it's important to look past the most common measure used by engineers (and management) in predicting if a project should be approved. That measure is Payback Time (PT). According to Robert Dunlap, a former chemical engineer at UOP and now a final-year MBA student at the University of Texas, "PT is flawed because it says nothing about what happens after the project is over and has to be lived with. Also, the time horizon associated with PT is arbitrary, based more on accounting standards' affinity for year-on-year and quarter-on-quarter results. PT associated with these results causes problems if your industry segment does not fluctuate on such an economic cycle. As such, use of PT leads to adverse selection toward projects deemed 'low-hanging fruit.'"
Dunlap favors the use of Net Present Value (NPV) or Internal Rate of Return (IRR). "The NPV of a project involves discounting all cash flows the project incurs and summing these discounted values to achieve a final number," he says. "That number is designated the NPV. If it is positive, then the project should be undertaken. IRR is related to NPV and solves for a discount rate that will result in an NPV of 0. This rate is the IRR. If the IRR is greater than the company's overall cost of capital, then the project should be accepted."
For examples of how to figure the discount rates associated with NPV and IRR for your next project, see this column online www.controleng.com/issues (when you select the October 2003 issue, you'll find the link in "Editorial" under "Departments").
"It is important to understand that these methods of determining project value are valuable because they move decision-making into a more appropriate area, as opposed to being based on temporary output boosts or on projects that appear to be doing well over the short run," says Dunlap. "Engineers must understand the value of making decisions this way because, in the long run, engineering is about economics."
David Greenfield, Editorial Director
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Why discounting cash flows is important.
The purpose of an asset is to give a person, a company, or any entity a stream
of cash flows. Because of accounting assumptions, the value of a nominal cash
flow appears to be constant over time.
| Year | Nominal Cash Flow |
| 1 | $1,000.00 |
| 2 | $1,000.00 |
| 3 | $1,000.00 |
| 4 | $1,000.00 |
| 5 | $1,000.00 |
| 6 | $1,000.00 |
| 7 | $1,000.00 |
| 8 | $1,000.00 |
| 9 | $1,000.00 |
| 10 | $1,000.00 |
| Sum | $10,000.00 |
But economics teaches us that all resources are scarce and uncertain. Finance, as a subset of economics, teaches us that cash flows in the future are worth less than today.
Because cash flows are uncertain, their value is decreased by a factor called the discount factor. The amount of risk/reward that a cash flow entails is reflected in its discount rate. Discount rates are like interest rates in reverse; they are how you allow for the opportunity of investing money elsewhere.
The amount to discount a future cash flow is given by 1/(1+r)t, where t is time and r is the discount rate in percent. The sum of the discounted cash flows is the Net Present Value (NPV) of an asset. When comparing economic or financial choices, NPVs should be used.
| Year | Nominal Cash Flow | Discounted Cash Flow |
| 0 | $1,000.00 | $1,000.00 |
| 2 | $1,000.00 | $857.34 |
| 3 | $1,000.00 | $793.83 |
| 4 | $1,000.00 | $735.03 |
| 5 | $1,000.00 | $680.58 |
| 6 | $1,000.00 | $630.17 |
| 7 | $1,000.00 | $583.49 |
| 8 | $1,000.00 | $540.27 |
| 9 | $1,000.00 | $500.25 |
| 10 | $1,000.00 | $463.19 |
| Net Present Value | $6,784.16 |
Discount rate 8%
As you can see, this value is significantly less than the nominal cash flows.
Let’s say that a cash flow is very risky. This is reflected in the discount rate. Just as a bank would charge a higher rate to allow for the chance of not receiving its money, a future cash flow is worth less if there is little chance of getting it. The same nominal flows above would be:
| Year | Nominal Cash Flow | Discounted Cash Flow |
| 0 | $1,000.00 | $1,000.00 |
| 2 | $1,000.00 | $743.16 |
| 3 | $1,000.00 | $640.66 |
| 4 | $1,000.00 | $552.29 |
| 5 | $1,000.00 | $476.11 |
| 6 | $1,000.00 | $410.44 |
| 7 | $1,000.00 | $353.83 |
| 8 | $1,000.00 | $305.03 |
| 9 | $1,000.00 | $262.95 |
| 10 | $1,000.00 | $226.68 |
| Net Present Value | $4,971.16 |
Discount rate 16%
You can see that the value of this decision, given by the NPV, is much less than the NPV in the first example. Cash flows can be either positive or negative, depending on whether you are receiving or giving money.
What should the discount rate be? A good approximation is the cost of capital paid. To give a spectrum of these rates, ExxonMobil's return on assets is 10.91%, General Electric's is 2.47%, Intel's is 8.07%. This is what a company pays to get money; this is what the assets return.
IRR is a related idea useful for a stream of cash flows that vary widely. IRR,
or internal rate of return, is what rate an investment would have to give to
have an NPV of 0.
choice that pays out with a rate better than NPV is a good decision. Here's the NPV for a machine you've bought for $10,000 that comes on stream slowly in the first year and ramps up, then gets old before retiring.
| Year | Nominal Cash Flow | Discounted Cash Flow |
| 0 | $(10,000.00) | $(10,000.00) |
| 2 | $200.00 | $125.80 |
| 3 | $3,000.00 | $1,496.51 |
| 4 | $5,000.00 | $1,978.10 |
| 5 | $5,000.00 | $1,568.80 |
| 6 | $6,000.00 | $1,493.03 |
| 7 | $7,000.00 | $1,381.44 |
| 8 | $6,000.00 | $939.09 |
| 9 | $5,000.00 | $620.65 |
| 10 | $4,000.00 | $393.78 |
| Net Present Value | $(2.82) |
Discount rate 26.09%
In this case, any project that has a discount rate of less than 26% (because you had to invest, and not finance) will have a positive NPV. The internal rate of return for this project is about 26%.
— Robert Dunlap
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