Investment Appraisal Techniques- Pros and Cons

INVESTMENT APPRAISAL TECHNIQUES – PAYBACK PERIOD, NPV, I RR, ARR

1. Payback period The payback period is the time taken to recoup the initial investment (in cash terms) out of its earnings. It is usually expressed in number of years and is worked out by dividing the earnings by the original investment. Payback calculates in cash flow terms how quickly a  project will take, to pay itself back. Its major assumption is that cash is received or accrued  evenly throughout the year.  Advantages 

Simple and easy to use- computation simplicity

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Easy to understand 

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Uses cash

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It emphasis on liquidity

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Minimizes further analysis- screens all projects

 Disadvantages  Disadvantages 

 No account of time value of money

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Ignores cash flows after the payback period 

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 No consideration for the length of investment investment

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Do not account properly for risks

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Cut off period is arbitrary

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Does not lead to value maximizing decisions

2. Net Present Value (NPV)

 NPV is the present value of the expected future cash flows minus the cost. It discounts future cash flows for an investment opportunity back to today’s values. NPV recognises that money received later in time is less valuable than money received today, this is because of the erosion of value through inflation and opportunity cost of lost interest. NPV uses an appropriate discount factor derived from a cost of capital to represent this effect which takes into account of the time value of money.

 Advantages 

Takes account of time value of money

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Theoretical link to shareholders wealth

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Looks at cash and not accounting earnings

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Considers the whole project from start to finish

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Includes risk into discount rate

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It indicates all future flows in today’s value which makes comparison of two mutually exclusive projects

 Disadvantages  

Estimates of discount rate  Not easily understood 

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Does not build in all risks

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Does not give visibility into how long a project will take to generate a positive NPV

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It is biased towards short run projects

3. Internal Rate of Return (IRR)

This is the cost of capital that if used would give a project a zero NPV, also understood as the ‘true return’ of a project. The decision criteria would be to accept all projects that give an IRR of more than or equal to the cost of capital for the company.  Advantages 

Takes account of time value of money

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Does not rely on exact estimate of cost of capital

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Uses cash flows rather than earnings

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Accounts for all cash flows

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Project IRR is a number with intuitive appeal

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It considers the profitability of the project for its entire economic life and hence enables evaluation of true profitability

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It provides for uniform ranking of various proposals due to the percentage rate of  return

 Disadvantages 

Can have multiple IRR (up to as many as changes in sign of cash flow)

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Percentage is relative

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 No direct connection to shareholders wealth

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 Not designed for comparing mutually exclusive projects

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Scale and timing problems

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More difficult and complex method 

4. Accounting Rate of Return (ARR)

ARR as it is commonly called is a profit based measure, using the profit and loss account and  accounting rules to determine an overall average profit or total profit of a project over the  period of its life time and comparing this to the investment amount as a percentage. ARR % = Average profit over the life of the project / Average investment x 100  Advantages 

Similar approach to ROCE

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Simple to calculate and easy to understand 

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Uses accounting figures

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It helps in comparing projects which differ widely

 Disadvantages   

 No account of time value of money It emphasis more on profit and less on cash flows  Needs a target percentage

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Percentages are relative and misleading in comparisons

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It does not differentiate between size of investments required for different projects

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It does not consider re-investment of profit over the years