Investment Appraisal Methods

1. Net Present Value (NPV)

The NPV is a project appraisal technique that uses appropriate discount rates to calculate the
expected future cash flows from a given project. The cash flows can either be positive (revenues)
or negative (expenses). The sum of the discounted cash flows less initial capital expenditure on
the project gives NPV of the profits in the present terms (Baker, 2011). The discount rate can
either be a company weighted average costs of capital or rate of return of alternative investments.
Riskier and longer investment requires the use of a high discount rate than safer and shorter
projects. According to the NPV technique, the cash available today is of higher value cash that
will be available in the future. A positive profit in the present terms is an indication that the
project is economically viable and should be accepted for investment purposes. However,
negative NPV shows the costs of the projects in present terms exceed its benefits, and it should
be rejected (Needles, Powers, & Crosson, 2010).
The NPV assumes that the reinvestment rate is equivalent to the hurdle rate, and the project cash
flows are discounted at the cost of capital. NPV approach also assumes that the rate of discount
does not change throughout the project lifetime. Besides, it assumes that a firm will immediately
reinvest cash flow once it is recovered. Finally, the NPV assumes rejection or acceptance of a
project cannot be changed once made. In other words, if an investment is accepted based on
positive cash flows, it cannot be revisited a year later when the project shows negative cash
flows. In such a case, it is reasonable for the firm to abandon the project altogether.
The NPV approach has been widely applied to appraise investment projects because it considers
the impact of time on the value of money. In this concept, cash available today is of higher value
than those expected in the future. Such conception is logical because if one has money today,
they can invest it to earn interest and money expected in the future can be affected by inflation
(Baker, 2011). The NPV approach accepts an investment with positive NPV, which means that it
increases the firms’ value and maximises shareholders’ wealth. NPV also takes into account all
the cash flows (negative and positive) from an investment throughout its lifetime, as well as
considers the risk and profits from an investment (Needles et al., 2010). However, the technique
is also limited because the discount rate and future cash flows that it uses are subjective. Thus,
NPV approach can be misleading if investors solely rely on it as a basis for evaluating projects.
Besides, if the projects have different initial capital outlays, the NPV cannot provide accurate
investment decisions because large projects involving more funds will have high NPV than small
ones, but that does not mean that large projects are better (Needles et al., 2010). NPV is a static
method and requires strategic decisions to be made at the onset of the project. As it does not
provide managerial flexibility and thus not applicable to rapidly changing the business
environment
2. Internal Rate of Return (IRR)
In addition to NPV, IRR can also be used to assess the viability of investment projects. The IRR,
as a discounting project appraisal technique, refers to the rate of interest or hurdle rate at which
the project cash flows present values of equals the initial capital investment present value.
According to IRR investment appraisal rules, acceptance or rejection of an investment project
depend on whether the IRR is more than or less than the hurdle rate. A firm should accept only
the project whose IRR is more than the cost of capital (Needles et al., 2010). Like NPV, IRR
views the cash at present time as more valuable those cash expected in the future as such it
maximises the shareholder's wealth. However, when the NPV and IRR approach results in
conflicting investment decisions, the project with high NPV is considered to maximize the wealth
of shareholders. The NPV is chosen over IRR because NPV is based on relatively realistic
assumption and provide a better measure of profitability than IRR. Besides, IRR results in
multiple values during a useful project life and make investment decision complicated. The NPV
and IRR approach would result in the same conclusion for non-mutually exclusive projects
invested in the unconstrained environment The IRR approach assumes that project future cash
flows during are invested into the project during its useful life at IRR. In addition to maximizing
the wealth of shareholders, firms using IRR for evaluation do not need to hurdle rate to assess
their projects. Thus, unlike NPV, the firms using IRR eliminate the risk associated with using
subjective hurdle rate (Hawawini & Viallet, 2007). The IRR approach is also simple and easy to
understand.
The IRR is limited in use, like other project appraisal techniques. The IRR has its limitations. The
IRR is a static approach that cannot be applied in the changing business environment. The
method is based on an unrealistic assumption that cash flow from the project is reinvested at IRR.
The assumption is far from being ideal because IRR can be more than the IRR that the existing
project's opportunities can generate (Needles et al., 2010). the approach also fails to take into
account the project size because it is focused on comparing the initial investment expenditure and
the project cash inflows. The contrast makes the technique less desirable if the two projects
require different initial capital outlay, with projects of small scale returning high IRR (Baker,
2011). The approach also ignores the potential future cost of the project such as the cost of
maintenance.
3. Payback Period (PBP)
The PBP refers to the required time by an investment project for its cash flows to equals its initial
capital outlay. An investment with a shorter PBP is more profitable and viable than those with a
longer PBP (Hawawini & Viallet, 2007). The technique is based on an implicit assumption that
returns to the investment continue beyond the PBP. The PBP approach is preferred over NPV and
IRR approaches because of its simplicity. However, unlike the NPV and IRR approach, PBP does
not discount cash flows and thus does not value cash at present as more valuable those to be
received in future. Therefore, PBP fails to maximize the value of the firm as well as the wealth of
shareholders (Baker, 2011). The PBP approach also fails to consider cash flows occurring after
the PBP. Thus, the method can view a project with substantial cash flow after the payback period
less economically desirable, yet such projects may have a high return and more preferable than
the one with shorter PBP. Besides, the payback period does not take into account project
profitability (Pandey, 2015). An investment with shorter useful life does not necessarily mean it
is profitable, because if cash flows end at a PBP then it would be unwise to undertake the project.
Unlike NPV and IRR, PBP is widely used in the changing business environment in which most
industrial companies operate. The approach is more suitable in the short life cycle of many
products and production technologies.
4. Discounted Payback Period (DPBP)
The failure of PBP to consider the cash at present as more valuable those to be received in future
resulted in the creation of a discounted payback period. The DPBP determines the period taken
for a project discounted cash flows to equal the initial capital outlay (Pandey, 2015). Thus, a
DPBP, like NPV and IRR considers that cash at present is more valuable than money to be
received in the future. Besides, the approach incorporates risk in evaluating projects because it
uses the discounted rate. Even though DBPP is simple and easy to understand as PBP, it fails to
determine if a project will increase firm value and thus does not maximize shareholders' wealth
(Brigham & Houston, 2013). Like, payback period, the approach can be used in a rapidly
changing business environment.
5. Accounting rate of Return (ARR)
The ARR is the rate of return that expected from an investment compared to the initial capital
outlay and involves dividing the net profit from a project by the initial investment. The approach
is applicable in determining the level of profitability of an investment and can be employed to
compare multiple projects (Brigham & Houston, 2013). The projects with the highest ARR are
considered to the most profitable. The ARR is an improvement of PBP because it considers the
project profitability. Like PBP, ARR is widely used in investment appraisal because of its
simplicity. The approach, however, fails to consider the money at present as more valuable than
those expected in the future. It also does not maximize the firm value of shareholders' wealth.
The ARR approach also has limited use because it uses accounting income rather than cash flows
(Pandey, 2015). Therefore, ARR may lead to misleading conclusions for investment projects with
high-level maintenance costs because such project is considered viable based on timely cash
inflows. ARR may also not lead to consistent decisions because of the different approaches
employed in its determination.
6. Profitability Index (PI)
PI refers to the ratio of investment cash flows present value to the initial capital outlay. The
objective of the approach is to compare the costs and benefits of a project. The lowest acceptable
ratio is 1.0. Thus, projects with a ratio lower than 1.0 should be rejected while those with a ratio
above one should be accepted. Like NPV, PI assumes project cash flows are invested back into
the firm at the hurdle rate (Brigham & Houston, 2013). The approach is similar to NPV and IRR
because it considers the time value of money and therefore maximises firm value and
shareholders' wealth. The PI also considers the risk in a project because it uses discounted cash
flows (Baker, 2011). However, it is different from the ARR and Payback period, which only
focusses on undiscounted cash flows. The PI disregards project size, and thus investments with
large cash flows may result in low PI because of low-profit margin. Like NPV, the PI used
discounted cash flows derived from subjective cost of capital and thus, may result in its wrong
investment decisions (Lumby & Jones, 2003). It also cannot be used to evaluate projects with
different useful lives. The approach is static and thus cannot be applied in a rapidly changing
business environment.
7. Equivalent Annual Annuity (EAA)
The EAA approach is suitable for evaluating mutually exclusive investments with different useful
lives (Petty, 2011). The method determines the constant annual project cash flows over the
project lifetime. EAA approach assumes assuming an investment is an ordinary annuity with the
same life span. It also assumes that a project NPV is equivalent to the present value of the
ordinary annuity. Besides, EAA assumes that the hurdle rate is equal to the required annual rate.
According to EAA approach, ordinary annuity is the same as ordinary perpetuity, and the present
value of the ordinary annuity is equivalent to project NPV. The project with higher EAA is
preferred (Brigham & Houston, 2013). The technique divided the NPV cash flows by the present
value of the annuity factor to derive annualized NPV. Like NPV, PI, DPB, and IRR, EAA
considers cash at present time as more valuable than those to be received in the future. Thus, it
maximizes firm value and shareholders' wealth. However, unlike NPV, PI and IRR that cannot
compare the project with unequal useful lives, EAA can be used for projects with different lives.
Like NPV and IRR, EAA is not effective in a business environment that is rapidly changing. The
EAA approach is limited because it assumes that projects can be replicated infinitely. Besides, it
assumes that cash flows and the cost of capital remain stable, which is unrealistic in practice.
 References

Baker, H. K. (2011). Capital Budgeting Valuation: Financial Analysis for Today's Investment

Projects. Hoboken: John Wiley & Sons

Brigham, E. F., & Houston, J. F. (2013). Fundamentals of financial management. Mason, Ohio:

South-Western.

Hawawini, G. A., & Viallet, C. (2007). Finance for Executives: Managing for value creation.

Mason, OH: South-Western/Cengage Learning.

Lumby, S., & Jones, C. (2003). Corporate finance: Theory & practice. London: Thomson.

Needles, B. E., Powers, M., & Crosson, S. V. (2010). Financial and managerial accounting.

Mason, OH: South-Western Cengage Learning

Pandey, I. M. (2015). Financial management. New Delhi: Vikas Publishing House PVT LTD.

Petty, J. W. (2011). Financial Management. Melbourne: P. Ed, Australia.