For the capacity to repay debt:
It is obvious that one must cover a sufficient number of periods to include the complete loan term. We must include a sufficient number of periods to cover outlays for replacement of assets because during the loan term the cost of replacements may severely interfere with planned cash flow and capacity to service debt.
For the PAY BACK method:
What is the minimum number of years to be included?
When an investment is measured using the PAY BACK technique, one must obviously go far enough to see the total investment recovered. Going beyond that period is useless because it will not change the outcome. Having to go beyond the useful life of the asset means the project does not earn back its investment.
For the IRR methods:
It appears quite obvious that the net present value of a cash flow must become higher if one includes more periods.
If the internal rate of return (IRROI or IRROE) method of measurement is used, the time span should be equal to the useful life of the longest-lived asset.
The useful life of an asset is not always easy to determine. Some assets are never fully depreciated or amortized, perhaps because the yearly maintenance seems to keep them operational forever. Perhaps the asset is an intangible. How far into the future is far enough to result in a believable outcome for our long-term planning purposes?
The farther out into the future one goes, the higher the resulting profitability rate is expected to be. Does that mean that an investment can be made twice as profitable by doubling the periods studied? Can an undesirable project be made to fall within the acceptable profitability ranges by simply increasing the number of periods studied? Is there a maximum time span beyond which one should not count?
As a rule of thumb, one should cover the useful life of the longest-lived asset under consideration and not longer since at the end of that time span, the asset is supposed to be replaced and the new investment has its own profitability rate. When the life of an asset is difficult to estimate, there is indeed some room for manipulation. Let us take a look at how much room there really is to inflate the outcome.
Several calculations were made for a five-year period. Successive investment values were elected in such a way that they would show a rate of return going from 5% to 50% in increments of 5%.
The values of the successive investments are shown on the following table. For each of the investment values, the project’s lifetime is successively extended from the original five years to 40 years, in steps of five years. The number of periods covered is shown in the first column of the table below.
Impact of Project’s Duration on the Resulting IRR
| Invested | 261 | 190 | 168 | 150 | 134 | 121 | 111 | 102 | 94 | 87 |
| Lifetime | ||||||||||
| 5 | 5% | 10% | 15% | 20% | 25% | 30% | 35% | 40% | 45% | 50% |
| 10 | 19% | 23% | 27% | 31% | 35% | 40% | 44% | 48% | 53% | 57% |
| 15 | 22% | 26% | 29% | 33% | 37% | 41% | 45% | 49% | 53% | 58% |
| 20 | 23% | 26% | 30% | 33% | 37% | 41% | 45% | 49% | 53% | 58% |
| 25 | 23% | 26% | 30% | 33% | 37% | 41% | 45% | 49% | 53% | 58% |
| 30 | 23% | 26% | 30% | 33% | 37% | 41% | 45% | 49% | 53% | 58% |
| 35 | 23% | 26% | 30% | 33% | 37% | 41% | 45% | 49% | 53% | 58% |
| 40 | 23% | 26% | 30% | 33% | 37% | 41% | 45% | 49% | 53% | 58% |
The results show, for example, that if a project with an investment of 150 covers five periods, it has a 20% rate of return, and that same project would show a 31% rate of return if the forecast covered 10 periods.
The results of 80 such trials are presented in the table, and one can observe a diminishing rate of increase for the profitability measures as the life of the project is expanded.
From the above table we can make the following generalizations:
- The longer the original number of periods covered, the less the addition of periods will change the resulting internal rate of return.
- The higher the internal rate of return, the less increasing the project life will change the results.
- If the original number of years is less than 10, adding periods will alter the outcome substantially.
- If the number of years covered is 10 to 15, adding periods will still alter the outcome noticeably. The lower the original result, the more adding periods will influence the outcome.
- If the original lifetime covered 15 or more years, extending the project is like adding cosmetics. It may, perhaps, veneer bad looks, but it will never turn a toad into a prince.
Hugo Daems studied law, politics, and business in European colleges and universities. He also holds an MBA degree from the University of California — Berkeley, where he majored in international business and finance. He has had more than 40 years of experience in this field, having held positions as a controller and lead project planner for several major companies. He founded H.E.A.D. CONSULTING Inc. in 1980 and was responsible for the planning and finance aspects of ventures in Europe, Africa, Asia, Central and South America, the Middle East, the South Pacific, the United States, and Canada.
