INVESTMENT APPRAISAL TECHNIQUES PAYBACK PERIOD, NPV, IRR, 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 No account of time value of money Ignores cash flows after the payback period No consideration for the length of 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 todays 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 todays 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