Guide
Payback, NPV and IRR explained for plant managers
What simple payback, discounted payback, net present value and internal rate of return each tell you, how to calculate them, and when finance will ask for which one.
By Dan Ghadiri · Updated · 8 min read
Key takeaway
Payback tells you how fast the money comes back, NPV tells you how much value the project creates at your company's required return, and IRR tells you the return rate the project earns. Use payback to screen and NPV to decide.
Plant managers usually think in payback. Finance teams often ask for NPV or IRR. They answer different questions, and a strong capital request shows the one finance uses alongside the one operations understands.
Simple payback
Simple payback is the number of years until cumulative savings equal the investment. With even annual savings:
simple payback (years) = capital cost ÷ annual net savings
It is quick and intuitive, which is why it's the standard screening metric. Its limits: it ignores the time value of money and ignores everything that happens after the payback point, including how long the equipment will last.
Simple ROI
simple ROI (%) = annual net savings ÷ capital cost × 100. It is the reciprocal of payback expressed as a percentage (a 2-year payback is a 50% simple ROI). Some companies define ROI over the whole project life instead, so check which definition your finance team uses.
Net present value (NPV)
NPV converts every future year's cash flow into today's dollars using a discount rate, then subtracts the investment:
NPV = −capital + Σ (cash flow in year t ÷ (1 + r)^t)
Here r is the discount rate, usually your company's hurdle rate. A positive NPV means the project earns more than that required return; a negative NPV means it earns less. Because NPV is in dollars, it's the best way to compare projects of different sizes and lives.
Internal rate of return (IRR)
IRR is the discount rate that makes NPV exactly zero. If IRR is above the hurdle rate, NPV at the hurdle rate is positive. IRR is popular because it's a single percentage, but it can mislead when comparing projects of very different sizes, and it can be ambiguous when cash flows change sign more than once.
Discounted payback
Discounted payback is payback calculated on discounted cash flows. It is always longer than simple payback and answers “how long until we've recovered the investment in today's dollars?”
Illustrative example
Illustrative example
Hypothetical round numbers for illustration only. Not data from any plant.
A hypothetical project costs $100,000 and saves $30,000 a year for 5 years, with no salvage value. The company's hurdle rate is 10%.
| Year | Savings | Discounted at 10% | Cumulative (discounted) |
|---|---|---|---|
| 0 | −$100,000 | −$100,000 | −$100,000 |
| 1 | $30,000 | $27,273 | −$72,727 |
| 2 | $30,000 | $24,793 | −$47,934 |
| 3 | $30,000 | $22,539 | −$25,394 |
| 4 | $30,000 | $20,490 | −$4,904 |
| 5 | $30,000 | $18,628 | $13,724 |
Simple payback = $100,000 ÷ $30,000 ≈ 3.3 years. Simple ROI = 30%. NPV at 10% ≈ $13,724 (positive, so the project clears the hurdle). IRR ≈ 15.2%. Discounted payback ≈ 4.3 years. If the equipment only lasted 4 years, NPV would be negative even though simple payback looks fine.
Which one to use
| Question | Metric |
|---|---|
| Is this worth a closer look? | Simple payback |
| Does it earn our required return? | NPV at the hurdle rate |
| Which of two projects creates more value? | NPV |
| What return does it earn, as a percentage? | IRR |
| How long is our cash at risk in today's dollars? | Discounted payback |
Common pitfalls
- Ignoring equipment life. A short payback on equipment that needs replacing soon can still destroy value.
- Seasonal cash flows. Savings arrive only in operating weeks. For seasonal plants, make sure the annual figure reflects the real season.
- Mixing before-tax and after-tax figures. Keep the whole model on one basis. Depreciation and tax treatment can change the answer; ask your accountant how your company handles them.
- Choosing your own discount rate. Use the hurdle rate finance sets.
- Optimistic savings. Run every metric on the conservative case too. See How to build a capital equipment ROI case.
Questions
- What is the difference between payback, NPV and IRR?
- Simple payback is how many years it takes for cumulative savings to equal the investment. NPV is the value today of all future cash flows minus the investment, discounted at your required rate. IRR is the discount rate at which NPV equals zero. Payback measures speed, NPV measures value created, and IRR expresses return as a percentage.
- What discount rate should a processing plant use for NPV?
- Use the hurdle rate your finance team sets, which is usually based on the company's cost of capital plus a margin for risk. Ask for it rather than choosing one; the same project can look very different at different rates.
- Is a shorter payback always better?
- Not necessarily. Payback ignores everything after the payback point, so a project with a slightly longer payback but a longer useful life can create more value. Use payback as a screen and NPV to compare.