Feasibility study basics: IRR, NPV and payback explained

Before committing capital to a new unit, location or expansion, owners, partners and lenders want to know whether it makes financial sense. A feasibility study answers that question with projections and a small set of measures. Here is what each one tells you.

Start with sound projections

Every measure depends on the cash flow projections underneath it: capital expenditure, revenue built from realistic volumes and prices, operating costs, working capital and taxes, usually over five years or more. Weak assumptions produce attractive but meaningless results.

Net present value (NPV)

NPV converts all the project’s future cash flows into today’s money using a discount rate, usually your cost of capital, and subtracts the initial investment. A positive NPV means the project is expected to add value after covering the cost of the money tied up in it. The higher the NPV, the more value it adds.

Internal rate of return (IRR)

IRR is the discount rate at which NPV becomes zero, in other words the annual return the project is expected to earn. You compare it with your cost of capital or a hurdle rate. IRR is easy to communicate, but it can mislead when cash flows change sign several times or when comparing projects of very different sizes.

Payback period

Payback is the time it takes for cumulative cash flows to recover the initial investment. It ignores what happens after that point and the time value of money, but it is a simple measure of risk: the longer the payback, the longer your capital is exposed. Lenders often look at it alongside debt service coverage.

A project with a high IRR but a long payback may still be too risky for a lender.

Where they disagree

Two projects can rank differently on NPV and IRR. A small project may have a higher IRR, while a larger one creates more total value and has a higher NPV. When choosing between mutually exclusive projects, NPV is usually the better guide, with IRR and payback as supporting measures.

Test the assumptions

• Run base, downside and upside scenarios.
• Show the break-even volume and price.
• Check sensitivity to the two or three assumptions that move the result most.
• Present the results with the assumptions behind them, so a reader can challenge them.