Module 1 of 1 · 60 minutes
Payback, net present value and the sunk cost trap
By the end of this module you will be able to
- Calculate a payback period and state its weakness
- Discount future cash flows and calculate net present value
- Interpret an internal rate of return
- Identify and exclude sunk costs
Amara Payback period. Everyone uses it. What is wrong with it?
Nadia Nothing is wrong with it as a first filter, and it survives because everybody in the room understands it instantly, which matters more than people admit. But it is blind in two directions.
Amara Go on.
Nadia It ignores everything after the payback point. A project paying back in three years then earning nothing beats a project paying back in four then earning for fifteen. And it treats a pound in year four as identical to a pound today.
Amara Which it is not.
Nadia Which it is not, for three reasons. Today's pound could be earning in the meantime. Inflation eats what the later one buys. And the later one might never turn up at all.
Amara So net present value fixes that.
Nadia It does, by discounting every future amount back into today's money so you can add them up honestly. Positive net present value means the project beats your required return. When two techniques disagree, trust this one.
Amara Where is the catch?
Nadia The discount rate. It carries the entire answer, and it is chosen by a person. I can take one project and make it obviously worthwhile or obviously not, using two rates that are both defensible.
Amara So how do I protect against that?
Nadia State the rate openly, and test the decision at a higher one. If the answer flips the moment you are slightly more cautious, the project is marginal and everybody should know that before signing.
Amara Last one, and this is the meeting I always lose. We have spent two hundred thousand pounds already.
Nadia Then that two hundred thousand is irrelevant. It is gone whatever you decide today. The only question is whether the future cash from continuing beats the future cash from stopping.
Amara It never feels irrelevant.
Nadia It never does, because stopping feels like admitting the first decision was wrong, and the person who made it is usually sitting at the table. That discomfort is not free. It is paid for with every further pound put into something that should already have ended.
The written material
Payback and accounting rate of return
Payback asks how long until the money comes back. It is simple, widely used, and understood by everybody in the room, which is why it survives despite two real weaknesses: it ignores everything that happens after the payback point, and it ignores the time value of money entirely.
Accounting rate of return expresses average profit as a percentage of the investment. It uses profit rather than cash, which makes it consistent with the reported accounts and less useful for a decision about whether money will actually be available.
The time value of money and net present value
A pound today is worth more than a pound in five years, for three separate reasons: it could be earning in the meantime, inflation erodes what the later pound buys, and the later pound carries risk of never arriving.
Discounting converts future cash into today's money so amounts separated by years can be compared honestly. Net present value is the sum of all discounted inflows less the initial outlay. A positive net present value means the project earns more than the required return, and it is the technique to trust when two techniques disagree.
The sunk cost trap
Money already spent is gone regardless of what is decided next. It is a sunk cost and it has no place in the appraisal. The only question is whether future cash from continuing beats future cash from stopping.
This is the most expensively broken rule in business, because stopping feels like admitting the earlier spend was wasted, and the person who authorised it is usually in the room. The cost of protecting that decision is paid by every further pound committed to a project that should already have ended.
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