Module 1 of 2 · 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 is the most widely used appraisal method. Is that a problem?
Nadia Not as a first filter. It survives because everybody in the room understands it instantly, and that matters more than textbooks admit. It is blind in two directions, though.
Amara Name them.
Nadia It ignores everything after the payback point, so a project paying back in three years then earning nothing beats one paying back in four then earning for fifteen. And it treats a pound in year four as identical to a pound today.
Amara Why is it not identical?
Nadia Three reasons. Today's pound can be earning in the interim. Inflation erodes what the later pound buys. And the later pound carries the risk of never arriving.
Amara Which net present value addresses.
Nadia By discounting every future amount into today's money so figures arising years apart can be added honestly. A positive net present value means the project beats the required return, and when two techniques disagree it is the one to trust.
Amara Where is it vulnerable?
Nadia The discount rate, which carries the entire answer and is chosen by a person. The same project can be made clearly worthwhile or clearly not using two rates that are both defensible.
Amara What controls for that?
Nadia State the rate openly and test the decision at a higher one. If the answer reverses under a slightly more cautious assumption, the project is marginal and the board should know that before signing.
Amara Two hundred thousand pounds is already spent. How does it affect the decision to continue?
Nadia It does not. It is gone under either decision, so it is a sunk cost and it belongs nowhere in the appraisal. The only question is whether future cash from continuing beats future cash from stopping.
Amara That is the most commonly broken rule in business.
Nadia And it breaks for a human reason rather than a technical one. Stopping reads as admitting the original decision was wrong, and the person who made it is usually at the table. That discomfort is paid for with every further pound committed to 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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