Imrul Kayas, ACA

Mobile: 01737231658

Investment Appraisal Techniques 

Traditional Techniques
1. Accounting rate of return (ARR) Based on Accounting profit
2. Payback period
Modern/ scientific Techniques
1. Net present Value (NPV)
2. Internal Rate of return (IRR) Based on relevant cash flow
3. Modified Internal Rate of return (MIRR)
4. Profitability Index
5. Discounted Payback period

Note: relevant cash flow = incremental cash flow

Accounting rate of return (ARR)

Average Annual Profit
 ARR Based on initial investment =
Initial Investment

Average Annual Profit

 ARR Based on Average investment =
Average Investment

Initial Investment + Salvage/crape Value

Note: Average investment =
2

Payback period
 Even cash flow
Initial Investment
PBP=
Annual Cash flow

Example: : (1,00,000) 45,000 45,000 45,000

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 Imrul Kayas, ACA
Mobile: 01737231658

100,000
PBP= =2.22∨2 years3 months (.22∗12=2.64∨3)
45,000

 Uneven cash flow

Initial Investment−cumulative cash flows of PBP
PBP= year of Payback period+ ×12
Followingcash flows of payback period

Example: (1,50,000) 35,000 40,000 45,000 50,000 55,000

Workings:
Period Cash flow Cum. Cash flow
0 (1,50,000)
1 35,000 35,000
2 40,000 75,000
3 45,000 120,000
4 50,000 170,000
5 55,000 225,000

150,000−120,000
PBP=3+ × 12
50,000
30 , 000
PBP=3+ ×12 = 3 years 7 Months
50,000

Note: Capital Rationing = Capital Limitation

Present value
PV of lump sum amount
FV
PV = ( 1+i )
n

Example: (1,00,000) 40,000 45,000 50,000

0 1 2 3
It is assumed that discount rate is 10%.
40,000 45,000 50,000
NPV ={−100000+ + +
1.10 1.1 0
2
1.10
3

2
 Imrul Kayas, ACA
Mobile: 01737231658

= 11119.45

PV of annuity in arrear
1
1− n
(1+i)
PV =FV ×
i
Example: : (1,00,000) 45,000 45,000 45,000 Discount rate is 10%

0 1 2 3

1
1−
(1+.10 )3
NPV= -1,00,000+ 45,000× .10
= -1,00,000+45,000×2.486= 11,870
PV of annuity is due
1
1−
(1+i)n
PV =FV × +1
i
Example: : 0 1 2

(1,00,000) 40,000 40,000

40,000

1
1−
(1+.10 )2
NPV= -1,00,000+ 40,000× .10 +1
= -1,00,000 + 40,000×2.735= 9400
PV of annuity is delay
1
1−
(1+i)n
PV =FV ×
i
n
(1+i)

Example : (-100,000) 60,000 60,000 60,000

0 1 2 3 4 5 6 7

3
 Imrul Kayas, ACA
Mobile: 01737231658

1
1−
(1+.10 )3
. 10
. 1 . 10 4

NPV= -1,00,000+ 60,000×

= -1,00,000+60,000×1.698
=1880
PV of perpetuity
FV
PV=
i
Example: If you invest taka 100,000 in XYZ Company, XYZ Company will give you taka 11000 in perpetuity.
11000
NPV = -100,000 +
.10
= 10,000

Internal Rate of return (IRR)

P
IRR=a+ (b−a)
P+ N
Here, a = Lower Discount Rate
b = Higher Discount Rate
P = Positive value of NPV
N = Negative value of NPV but absolute figure (Positive figure)
Note: Discount Rate = WACC/
If discount rate high, NPV low
If discount rate low, NPV high

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 Imrul Kayas, ACA
Mobile: 01737231658

5
 Imrul Kayas, ACA
Mobile: 01737231658

Modified Internal Rate of return (MIRR)

PVr = Present Value of net receipt
PVi = Present Value of investment
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 Imrul Kayas, ACA
Mobile: 01737231658

Example: : (1,50,000) 40,000 40,000 40,000 40,000 40,000 Discount rate is 10%

0 1 2 3 4 5

PV of annuity = 40,000 ×

= 151,631

=10.24

[In cal: 151,631÷150,000=Result ̂ .20 = Result × 1.10-1]

Advantages of MIRR
 MIRR overcomes 2 major drawbacks of IRR including the elimination of multiple IRRs in case
of investments with unusual timing of cash flows and secondly the re-investment
problem discussed earlier.Helps in the measurement of sensitivity of an investment towards
variation in the cost of capital.
Limitations of MIRR
 As with IRR, MIRR may lead to sub-optimal decision making when multiple investment options
are being considered. As MIRR does not quantify the impact of different investments on the
wealth of investors in absolute terms, NPV provides a more effective theoretical basis for
selecting investments that are mutually exclusive (i.e. where the selection of one investment
results in the abandonment of another investment, e.g. due to shortage of funds).
 MIRR can be hard to understand for people belonging from a non-financial background. The
theoretical basis for MIRR is also disputed among academics.

Profitability Index
PV of net receipt
PI =
Initial Investment
151,000
PI = =1.0108
150,000
If PV > 1, Project is accepted
If PV < 1, Project is rejected

Discounted Payback period

7
 Imrul Kayas, ACA
Mobile: 01737231658

Period Cash flow Discount 10% Discounted Cash Cumulative Cash

(1/1.10)n flow Flow
0 (150,000) 1
1 40,000 .909 36,364 36,364
2 40,000 .826 33,056 69,420
3 40,000 .751 30,052 99,472
4 40,000 .683 27,320 126,792
5 40,000 .621 24,836 151,628
150,000−126,792
PBP=4 + ×12
24,836
23,208
PBP=4 + ×12 = 4 years 11 Months
24,836