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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
Easy to understand
Uses cash
It emphasis on liquidity
Minimizes further analysis- screens all projects
Disadvantages Disadvantages
No account of time value of money
Ignores cash flows after the payback period
No consideration for the length of investment investment
Do not account properly for risks
Cut off period is arbitrary
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
Theoretical link to shareholders wealth
Looks at cash and not accounting earnings
Considers the whole project from start to finish
Includes risk into discount rate
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
Does not build in all risks
Does not give visibility into how long a project will take to generate a positive NPV
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
Does not rely on exact estimate of cost of capital
Uses cash flows rather than earnings
Accounts for all cash flows
Project IRR is a number with intuitive appeal
It considers the profitability of the project for its entire economic life and hence enables evaluation of true profitability
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)
Percentage is relative
No direct connection to shareholders wealth
Not designed for comparing mutually exclusive projects
Scale and timing problems
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
Simple to calculate and easy to understand
Uses accounting figures
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
Percentages are relative and misleading in comparisons
It does not differentiate between size of investments required for different projects
It does not consider re-investment of profit over the years
