INTRODUCTION

The money spent by an entity or corporation to acquire, maintain, or improve fixed assets
such as buildings, vehicles, equipment, or property is referred to as capital expenditure or
capital expense.  When an investment spending represents a significant financial decision for
a company, it must be acknowledged at an annual shareholder meeting or a special meeting
of the Board of Directors. In today's highly competitive and ever-changing global business,
capital expenditures are a must. One of the most tough responsibilities of top management is
making decisions on capital expenditure. (Kaplan, June 2021)Decisions which are made
based on ill-defined criteria and intuitive judgement can jeopardize the liquidity for the
company in future. Capital investment decisions are crucial to a company's long-term
existence so it requires thorough planning before a decision is made. Investment appraisal
acts as an input to the Investment decision process which justifies the portfolio’s Investment.
The inherent subjectivity involved in attempting to foresee the future complicates the
investing decision even further. (Kaplan, 2021)

Abstract
Several companies have lost their identities or been liquidated as a result of poor capital
budgeting decisions made at one point or another. Given the prevalence of industry
difficulties and the impact of globalisation on industries, it is critical to employ effective
methods for analysing investment before making a choice. Capital budgeting is critical since
the decisions made affect the organization's future orientation and growth opportunities. The
process through which investors assess the worth of a possible investment project is known as
capital budgeting. (Adrian, 1996) Capital budgeting entails identifying projects that offer
value to a business. This report is focused on four main investment appraisal techniques. It
includes IRR, NPV, ARR, and Payback Period. To begin, this paper examines the benefits
and drawbacks of these strategies. It is followed by a critical assessment of potential practical
issues that identifies gaps in theory and practise. Capital investment decisions, like many
other sensitive aspects of finance, have been the topic of heated debate over the years
however according to some experts, the gap between theory and practical world is not as
small as previously thought. Net Present Value is the most popular technique for Investment
Appraisal used in the practical world. This method emphasises the time worth of money and
is consistent with the company's goal of maximising shareholder wealth. (XinWang, 2010)

Investment Appraisal Techniques

There are several investment appraisal techniques. However, IRR, NPV, ARR, and Payback
Period.
Amongst all Investment Appraisal Techniques mentioned above Net Present Value is the
most popular method for Investment Appraisal. This method emphasises the time worth of
money and is consistent with the company's goal of maximising shareholder wealth. Now let
us discuss each method in detail and discuss the advantages and disadvantages of the
techniques in the light of the literature.

Literature Review
Net Present Value
The difference between the present value of the cost inflows and the present value of the cash
outflows is known as the Net Present Value. In other words, a project's net present value is
the present value of the project's cash flows from operations and disinvestment less the
amount of the initial investment, usually estimated as of the time of the initial investment.
The cash flows happening at different periods in time are adjusted for the time value of
money using a discount rate that is the minimal rate of return required for the project to be
acceptable when assessing the project's net present value. Positive net present values are
acceptable, but negative net present values are unacceptable. (Gallo, 2014)The Net Present
Value (NPV) indicator is amongst the most crucial ones in capital budgeting. In particular, it
allows assessing the value of the future cash flows based on the estimated discount rate. NPV
is a capital budgeting tool that analyses the profitability of a project or investment. It is
sensitive to the predictability of future cash flows that the project or investment will generate.
Time value of money is the concept that money promised or due in the future is worth less
than money now. The main advantage of NPV is that NPV is a simple method for calculating
the profitability of an investment portfolio based on its predicted future cash flows and
determining whether it will improve the entity's worth. Another benefit is that it enables the
organisation to determine when they may anticipate to break even or make a profit from their
investment portfolio by comparing cash inflows to the initial investment cost. Also, it does
not ignore any period in the project life of cash flows any easy method to calculate as
compared to IRR and takes into account time value of money.
One of the NPV flaw is NPV is primarily reliant on estimates, it expects the management to
know the correct cost of capital for that project and putting the entity's projections at risk of
being inaccurate. NPV distorts comparisons across projects of different sizes or life cycles.
Furthermore, some have stated that because the rate of return is determined by the overall
amount, it is difficult for non-finance experts to comprehend and express it. (Juhász, 2011)

Payback Period
The payback period is the amount of time it takes to repay the cost of an investment or to
reach the breakeven point for an investor. Extended payback periods would be less desirable,
while shorter payback periods are more attractive. Despite its theoretical flaws, the payback
method is widely employed for evaluating capital budgeting initiatives in businesses. When
project time risk and liquidity are emphasized, as well as when pure profit evaluation is
employed as a single criterion, the payback approach is frequently used. The payback method
is frequently used as a preliminary screening tool to separate the evident situations of
lucrative and unprofitable investments. In small and medium-sized businesses, the payback
technique is frequently utilised as the primary or only method. (Gallo, 2016) In industrialised
countries such as the United Kingdom and the United States, the payback period has proven
to be a significant, popular, primary, and conventional strategy. Managers appear to predict a
payback period of two to four years in the majority of cases. By definition, the payback
method only considers project returns up to the payback period. Certain projects, however,
that are long-term in nature and whose advantages will accrue sometime in the future and
well beyond the standard payback period, may not be accepted based on the payback
method's calculation, even if they are critical to the company's long-term success. As a result,
the payback approach should be used as a measure of project liquidity rather than project
profitability. The payback method's key flaws are that it overlooks cash flows after the
payback period and that it does not accurately evaluate the time value of money.
(HAJDASIŃSKI, 1993) Theorists have attacked the payback period limit because it ignores
income that may accumulate during the project's future life after the payback period. The
advantages of Payback Period is it is a method which is extensively used and understood and
it does not tackle risk directly, it allows a financial management to deal with risk by
analysing how long it will take to return original investment. Also, because of the ease of
usage and interpretation, capital budgeting decisions can be decentralised, increasing the
chances that only worthy things make it into the final budget. (Boardman, 1982)

Internal Rate of Return

The internal rate of return (IRR) is a discount rate that makes the net present value of all cash
flows from a project equal to zero. It is commonly used in capital budgeting. In essence, IRR
is the rate of return that makes the total of the present value of future cash flows and the
project's end market value equal its current market value. The higher the internal rate of
return on a project, the more appealing it is to take it on. As a result, it's utilised to rate a
number of potential initiatives that a company is investigating. (Schafrick, 2010) As a result,
the internal rate of return serves as a basic checkpoint: any project whose cost of capital
exceeds this rate should be avoided. Accepting a project if its internal rate of return exceeds
the cost of capital and rejecting it if the IRR is less than the cost of capital is a simple
decision-making criterion. Although it should be noted that using IRR can lead to a variety of
complications, such as a project with numerous IRRs or no IRR, as well as the fact that IRR
ignores the project's size and assumes that cash flows are reinvested at a constant pace. The
relative simplicity with which most managers can grasp the IRR as a percentage of
investment gains is a significant advantage of IRR over the NPV technique of investment
evaluation. The time value of money and discounted cash flows are also factors to consider.
There are certain drawbacks to using the internal rate of return (IRR) technique for capital
investment evaluation, such as it frequently yields exaggerated rates of return, and it should
not be used to accept or reject a project unless the computed IRR yields an acceptable rate of
reinvestment of future cash flows. Another drawback is being the difficulty of a double
internal rate of return due to the combination of net cash flows, including non-conventional
cash flows (IRR). (Dorfman, 1981) The internal rate of return technique, particularly with
jointly exclusive capital investments, may lead to differing findings about the type of project
that should be approved, according to the Net present value (NPV) method. When the cost of
capital is less than the IRR, the IRR technique of evaluating investments presupposes that
cash flows received during the venture can be reinvested. This assumption usually leads to an
overestimation of investment returns. Another flaw with the IRR is that it ignores the volume
of investments, which has an impact on the maximisation of shareholder value in mutually
exclusive projects. Because of the variable cost of capital and unpredictable cash flows, it's
vital to remember that the internal rates of return of various assets cannot be combined. They
observed that when a project's internal rate of return (IRR) is high, the basic concept of
reinvesting the project's IRR cash flows across its useful life is utterly unrealistic. (Wright,
1978)

Accounting Rate of Return (ARR)

The accounting rate of return, commonly known as the return on investment, expresses
annual accounting earnings as a percentage of the initial investment. As can be seen, unlike
investment assessment methodologies such as net present value, the accounting rate of return
analyses profits rather than cash flows. The accounting rate of return (ARR) technique of
evaluating investments is particularly simple for non-finance experts to grasp because it is
based on accounting profits. When investors or managers need to analyse a project's return
fast, ARR comes in useful because it doesn't take into account the time frame or payment
schedule, only the profitability. (Penman, 1991). The accounting rate of return (ARR)
formula is useful for calculating a project's yearly percentage rate of return. When evaluating
numerous projects, ARR is widely employed because it calculates the expected rate of return
for each one. One of ARR's flaws is that it doesn't distinguish between investments that
produce distinct cash flows over the project's lifetime. ARR does not take into account the
time value of money or cash flows, which are important aspects of running a firm. (Stark,
1980)
Potential Practical Problems in the use of Investment Appraisal Techniques

Over the last few decades, key investment obstacles have dissolved, and capital may now be
transmitted to almost any corner of the world with the mouse click. Fewer obstacles to
capital, products, services, and labour movement allow for better, more effective resource
allocation, resulting in higher total production. The European Single Market, which is
currently the world's largest free trade region, is built on the four freedoms of movement
listed above. There should be a single business language for all those doing business in
Europe, including multinationals, financial analysts, and even small businesses. It's the
language of investment appraisal methods. Measures like Net Present Value, Internal Rate of
Return, and plenty of other indicators become the "meta-language" of business when properly
calculated, communicated, and interpreted, condensing information and allowing for
comparisons of expected investment effectiveness across projects, sectors, and markets,
regardless of nationality or corporate culture. (Zarzecki, 2020). Investment appraisal methods
can be divided into two main groups – traditional methods such as Payback Period, Return on
Investment, Return on Equity, Accounting Rate of Return, or Return on Capital Employed
can be classified into two primary divisions. All of the above have one thing in common: they
do not account for the time value of money, and so do not require a discount rate to reflect,
for example, market returns or risk. Naturally, it is also their most serious weakness —
particularly in the case of long-term investment initiatives. Methods from the second group,
i.e Discounting methods, such as Net Present Value, Profitability Index, Internal Rate of
Return, and Modified Internal Rate of Return, all have the same underlying logic: performing
a comprehensive assessment of a given investment's effectiveness necessitates forecasting the
cash flows that it is expected to generate and then discounting them to reflect time value of
money.
Markovics (Markovics, 2016) published a recent work that featured a complete evaluation of
prior research into the topic matter for a number of European countries as well as the United
States. The report compiled the findings of many polls done over several decades (from 1975
to 2015) and examined important findings regarding the popularity of investment evaluation
approaches in specific European nations. According to the report, less than half of the
examined companies used the most complete investment appraisal approach, NPV. On the
other hand, a significant number of financial managers from various European countries
admitted to employing simplistic investment appraisal methodologies such as Payback Period
and Accounting Rate of Return that do not account for the time worth of money. Having
come to the conclusion that investment appraisal methods, particularly the more sophisticated
ones like NPV and IRR, were grossly devalued in small businesses - SMEs preferred simple
indicators like Payback Period. Firm size appears to be a significant factor influencing the
popularity of investment appraisal methods. Furthermore, they concluded that discounting
approaches were more common in high-income countries when comparing their findings to
earlier research. (Peel, 1998)
Another intriguing aspect of the Dutch survey is that it found a statistically significant link
between the age of a company's CFO and the use of NPV — the older the CFO, the less often
NPV was used. In the United Kingdom, decision-makers preferred the internal rate of return
to the net present value of the two discounted cash-flow methodologies offered in the study.
The payback period is the method used by practically all British businesses to calculate ROI
during the planning stages of their investment decisions. In terms of techniques that take the
time value of money into account, there was a difference in corporate executives' preferences:
internal rate of return was more frequently used in the case of British and French enterprises,
whereas net present value was more frequently used in the case of their Dutch and German
counterparts when evaluating investment alternatives. (Rossi, 2014)The use of the
profitability index was more common than the computation of the net present value among
French businesses, which was important to note.
Liljeblom and Vaihekoski (Liljeblom, 2004)questioned finance leaders of companies listed
on the Finnish stock exchange regarding their investment decisions in 2002. The purpose of
the survey was to find out which capital budgeting methodologies were utilised by Finnish
companies to evaluate their investment projects, either first or later. According to the study,
they utilised the payback time and internal rate of return as major criteria for evaluating their
investments, and they did not choose the profitability index, unlike their French counterparts.
In contrast to their Finnish counterparts, the net present value was the most commonly
utilised capital budgeting method among Swedish companies: 61.14 percent of respondents
stated they used it "always" or "often" in the decision-making process with a rate of 54.4
percent, the payback period was the second most popular approach, followed by the internal
rate of return, the accounting rate of return, and the profitability index.
Both the core non-discounted and discounted cash-flow approaches can be found in today's
relevant literature on company management, however the writers convey the substance of
each method with varying degrees of detail and depth, often in a slightly deceptive fashion.
However, there appears to be agreement in advising the use of discounted methods in practise
that take into account the time worth of money.
According to the findings of studies conducted in European countries, corporate professionals
frequently calculate the payback period; however, some researchers claim that this indicator
is only used for orientation, and that investment decisions are primarily evaluated using
discounted cash-flow methods. It was also clear that among the time value of money
methodologies, the net present value and the internal rate of return were the two most
commonly used in the examined companies.

References

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