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Investment appraisal techniques

Techniques

Pay Back of
Accounting Time Value of
Capital
Profit Money
Employed

Pay Back Accounting Net Present


Period Rate of Return Value Method

Earnings per Internal Rate of


Share Return

Net Terminal
Value Method

Profitability
Index Method

Discounted Pay
Back Period
Method
Method Criteria

PBP < Target Period = Accept


1. Pay Back Period PBP > Target Period = Reject

ARR > Target Rate = Accept


2. Accounting Rate of Return ARR < Target Rate = Reject

NPV > Zero = Accept


3. Net Present Value NPV < Zero = Reject

IRR > Cost of Capital = Accept


4. Internal Rate of Return
IRR < Cost of Capital = Reject
PI >1 = Accept
5. Profitability Index
PI <1 = Reject
• Advantages • Disadvantages
• The payback method is popular with • The payback method ignores the time
business analysts for several reasons. value of money. The cash inflows from a
The first is its simplicity. Most project may be irregular, with most of
companies will use a team of employees the return not occurring until well into
with varied backgrounds to evaluate the future. A project could have an
capital projects. Using the payback acceptable rate of return but still not
method and reducing the evaluation to meet the company's required minimum
a simple number of years is an easily payback period. The payback model
understood concept. Identifying does not consider cash inflows from a
projects that provide the fastest return project that may occur after the initial
on investment is particularly important investment has been recovered. Most
for companies with limited cash that major capital expenditures have a long
need to recover their money as quickly life span and continue to provide
as possible. Managers use the payback income long after the payback period.
method to make quick evaluations of Since the payback method focuses on
projects with small investment. These short-term profitability, an attractive
small projects do not necessarily involve project could be overlooked if the
a group of employees, and it is not payback period is the only
necessary to conduct a rigorous consideration.
economic analysis.