The evaluation of an investment project is based on the comparison between the expected profitability of the project and the cost of the financial resources mobilized to finance it (the Weighted Average Cost of Capital or WACC).

To measure this performance, financiers use three complementary criteria: NPV (for absolute value), IRR  (for relative profitability) and Payback (for risk and liquidity).

Here’s how each criterion is used:

1. Net Present Value (NPV): The measure of wealth creation

NPV is the central criterion because it directly measures value creation. It is the difference between the sum of the discounted cash flows generated by the project and the amount of the initial investment.

• The principle: A project creates value if its NPV is positive. This means that the project is yielding more than it cost, while having remunerated the capital providers (shareholders and creditors) at the rate they demanded (the WACC).
• Calculating Free Cash Flows: These are not accounting profits, but free cash flows. The standard formula is:
  • Cash Flow = EBITDA × (1 – Tax Rate) + Depreciation and amortization × (Tax Rate) – Change in WCR.
  • It is imperative to use nominal cash flows  (including price and cost inflation) discounted with a nominal rate to capture the effects of differential inflation.
• Interpretation: NPV represents the absolute enrichment of shareholders.

2. Internal Rate of Return (IRR): The measurement of intrinsic performance

The IRR is the discount rate that cancels out the NPV (NPV = 0). It is a relative performance indicator (expressed in %).

• The principle: A project is acceptable if its IRR is higher than the WACC. The difference between the IRR and the WACC is the “economic profit” of the project.
• The major limitations: Although popular, TRI has technical and economic drawbacks:
  1. Reinvestment Assumption: IRR assumes that intermediate cash flows are reinvested at the rate of the IRR itself, which is often unrealistic for highly profitable projects.
  2. Multiple solutions: If the sequence of flows changes sign several times (e.g. initial investment, positive flows, then large final investment or dismantling cost), there may be several IRRs, making the criterion unusable.
• The alternative (MRR): To correct these biases, it is recommended to calculate the Modified Rate of Return (MRR). This updates investments and capitalizes income at the WACC rate (more realistic), providing a more robust measure of profitability.

3. Payback: The measure of risk and liquidity

The payback answers the question: “When do I get my stake back?” It is an indicator of temporal risk.

• Nominal Payback (Incomplete): It measures the time it takes for the sum of undiscounted cash flows to  cover the initial investment. It is considered incomplete because it ignores the return on capital (time is money).
• Discounted Payback (Relevant): It measures the time it takes to recoup the initial investment from the discounted cash flows. At that point, the project not only repaid the principal, but also remunerated the investors at the required rate (WACC).
• Use: This delay must be compared with the visibility of the company (order book, product life cycle). A project with a long payback (e.g. 7 years) is acceptable if the visibility is long (e.g. 20 years), but very risky if the future is uncertain.

Summary of the evaluation

For a comprehensive assessment, it is recommended that these criteria be used in conjunction with:

• NPV  indicates how much value is created (the amount in foreign currency).
• The IRR (or better, the MRR) indicates the effectiveness of this investment (the return in %).
• The discounted Payback indicates the risk horizon (the duration of financial exposure).