organization’s investment expectations, so your project is likely to
be approved (if there’s enough cash to fund it).
To calculate the internal rate of return, use the same formula.
However, set NPV to zero and solve the equation for “r.” The
resulting figure, expressed in terms of a percentage, represents
the effective yield that your project will bring to your organization.
The third financial metric, payback period or time to money,
occurs when the cumulative discounted cash flow is zero, sig-
naling the return of the original investment (as shown in Figure
4-2). In this example, the payback period ends between years
six and seven.
Finally, the cash hole or maximum exposure occurs at the
point where the cumulative negative cash flow is greatest. In the
example shown in Figure 4-2, the maximum exposure is
expected to be $181,000, three years after project initiation.
Using Non-Financial Criteria for Project Selection
Financial models express costs and benefits in dollars and
cents. As mentioned earlier, estimating certain kinds of benefits
in financial terms can be quite difficult or uncomfortable. In
other situations, accurate data may be obtainable, but only by
conducting expensive tests, studies, or surveys. Whenever the
process of getting good financial data is difficult, expensive, or
time-consuming, using a weighted factor scoring model (deci-
sion matrix) may be a reasonable option for selecting the best
alternative solution.
Figure 4-4 shows a decision matrix constructed to deter-
mine the preferred model of automobile. We’ve identified six
Defining Your Project 63NPV =Cash FlowYear 0
(1+r)^0Cash FlowYear 1
+ (1+r) 1Cash FlowYear 2
+ (1+r) 2Cash FlowYear n
+ (1+r)n
...Where
n = Useful life of investment
r = the discount rate, cost of capital, or required return that is what
the investor could expect to receive from any other investment
consistent with investor's risk tolerance
Figure 4-3. Formula for finding NPV