Investment appraisal techniques refer to the methods used to assess the viability and profitability of potential investments. There are several commonly used techniques including payback period, accounting rate of return, net present value (NPV), internal rate of return (IRR), and profitability index. Each technique has its own advantages and limitations. When evaluating an investment, it is important to consider factors like the time value of money, opportunity cost, inflation, risk, capital constraints etc. Using multiple techniques together can provide a more comprehensive analysis for decision making. This article will discuss the core investment appraisal techniques and their usage.
Payback period focuses on the liquidity of an investment
The payback period measures the length of time required for the cumulative cash inflows from a project to equal the initial investment outlay. It is useful for assessing liquidity risk and projects with relatively short lives. However, it ignores the time value of money and cash flows after the payback period. So it should not be used alone for long-term investments.
Accounting rate of return examines accounting profitability
Accounting rate of return (ARR) measures the average annual accounting profit from a project as a percentage of the initial investment. It is easy to calculate but ignores the time value of money. ARR also uses accounting profits not cash flows, so non-cash items like depreciation can distort results.
NPV incorporates the time value of money
Net present value (NPV) discounts all expected future cash flows to the present and subtracts the initial investment. It accounts for the time value of money and gives the net contribution to wealth. NPV is suitable for capital budgeting decisions but requires an appropriate discount rate. It may also incorrectly value projects with interim cash flows.
IRR allows ranking and comparison of investments
The internal rate of return (IRR) solves for the discount rate that makes the NPV of a project equal to zero. A higher IRR indicates a more desirable investment. IRR permits the ranking and selection of multiple projects when capital is constrained. However, it may give inaccurate results for mutually exclusive projects.
Profitability index measures value created per unit invested
The profitability index is calculated as the present value of future cash flows divided by the initial investment. It shows the value created per unit of investment. The higher the index, the more attractive the project. However, it cannot rank projects of different sizes or identify the optimal investment combination.
In summary, each investment appraisal technique has its own strengths and limitations. Using a combination of NPV, IRR, payback period, ARR and profitability index can provide a robust analysis for investment decision making. The techniques help assess profitability, risk, timing of cash flows and capital constraints.