Small Business Doctor

Are IRR and payback really always so bad for financial decision-making? Why do so many people use them if NPV is so much better?

IRR and payback are not bad for financial decision-making. They provide you with different information about a potential investment or project than does NPV. To the academics of finance and accounting, NPV is always superior, because it cleanly provides you with exactly how much value a proposed investment project will provide the company in dollars and cents. If that’s the information that you need, then NPV is always the way to go.

In the real world, however, and especially for small business financial decisions, information about exactly how much value will be provided by a proposed project is less relevant than how long their cash will be tied up in a project that has not yet returned that cash. Small businesses are and should be extremely sensitive to cash flows. Unlike Ford Motor Company, Windmill Bakery does not have ready access to capital, and inadequate cash access is the number one killer of small businesses in America. So small business financial advisors need to go beyond textbook finance to provide small business decision makers with all relevant financial considerations.

This constraint makes information about the timing of projected cash flows much more important than information about projected value creation. So, IRR and payback will tell a small business decision maker information about both value creation and how long their cash will be tied up in this project in a way that prioritizes the information about the return of that cash.

This prioritization is also why even though a detailed NPV calculation does present information about cash flows, because it is buried within the calculation, it is less useful than IRR or payback. The simpler IRR and payback calculations return the relevant information more easily and quickly.

And, no, including this cash flow time sensitivity into the discount rate used within an NPV calculation does not resolve this issue because that is putting the cart before the horse. Time sensitivity is more salient than the amount of value creation in these scenarios so the simpler IRR and payback calculations can provide a better decision screen.

I like to tell the financial managers I mentor that this is like the situation where dad is asked for the car keys by his teenager. Typically, the dad will ask 2 questions. Where are you going? What time will you be back? They’re both important questions. The answer to each question can potentially be a deal breaker.

The first question about where the teen is going is simple and binary. There will be some destinations and some roads that are off limits. Drug den destinations or interstate highway answers should result in a no. This is like the projected profitability answer that NPV seeks to answer with detail and specificity. It gives you the ultimate destination and the details of the path towards that destination. This is all very useful information, and if this journey only involved capable and competent adults, this may be all the information needed.

However, at the end of the day in the real world, it doesn’t matter that much to dad if the teen is going bowling with his friends or on a date with his girlfriend. They’re both good answers, and deciding between these two good things is less important than the answer to the second question. NPV only really answers this question, and if you need to decide between bowling with friends and a date with the girlfriend, then NPV is your guide.

The second question about when the teen will be back is about limits and risk. The dad might need the car back at some time to run an errand, and so needs to ensure that this need is addressed. There are limits to how long the teen can borrow the car.

Importantly, and this is glossed over by finance academics, the dad also knows that risk increases the longer the teen is driving the car and crucially that not all times of day are equally risky. A teen borrowing the family car until 3am is at almost infinitely more risk than the teen borrowing the car until 3pm.

This question about time is like the time-based answer that IRR and payback period metrics try to answer. If the payback period will extend into or even threaten to extend into my busy season when I need to do X with that cash, then that is a deal breaker. And, if there isn’t a clearly defined endpoint that meets the real life needs of the business, then that too is a deal breaker.

From an academic perspective, time is a fungible commodity. It’s all the same. To them, the only salient aspect to time is its distance from the present. There are no times that are riskier than other times. There are no hard deadlines.

Like a parent of a teen, to a small business owner in the real world, this is not at all true or realistic. It is inherently more risky to have my cash tied up in a capital project during a busy season or when I need to prepare for a busy season. Similarly, if my small business has been experiencing cash flow issues or wild revenue fluctuations recently, then the near future looks very different than some generic future time.

Wisely, that small business financial manager would only let a project use that cash for a brief and well-defined period of time. And might wisely turn down a project that promised to double the return of a project that took a bit less than twice the time. In theory, future time’s all the same. In real life, it all depends on the situation. Maybe it’s the time of day, and maybe it’s that the car has been making strange sounds. It depends on the situation.

There is wisdom in the questions a parent will ask of their child. The credentials and proofs of an academic do not negate that wisdom no matter how well they may pretend that those parental concerns are misguided or uninformed.

This is why these older financial decision-making metrics continue to persist, especially in small businesses. Small business financial decision makers continue to use IRR and payback instead of only using NPV not because they are too stupid or uninformed to get with the NPV or EVA program, but because their small business experience has wisened them to the need to consider more than the precise projected benefit a proposed project will afford their small business.

The takeaway is that there is not one single decision-making financial metric to rule them all. Different metrics tell us different information. Because companies come in all different shapes and sizes, financial managers need to understand all of the financial measurements to be able to identify those that will provide the most useful information for their particular company.