Compare and contrast the 4 main methods of investment appraisal that businesses use.
Methods of investment appraisal use by Businesses
Comparing and contrasting the four main methods of investment appraisal that business use:
It is prudent for organizations to completely evaluate every capital investment decisions through sound appraisal methods. The main reason for doing this is that, these investments involve commitment of large sums of funds; they take a long time, require much commitment from the management and are irreversible. The four major techniques used for evaluating investment in capital projects include: accounting rate of return (ARR), Payback period technique, net present value (NPV) technique, and internal rate of return (IRR) (Gotze, et al., 2007).
Each of the method has a different approach to evaluating the worth of an investment or project for an organization. Whereas the last three techniques focus on cash flow, the first technique (the accounting rate of return (ARR) also called return on investment (ROI) uses accounting profit during its appraisal calculation, offering a view of the general profitability of the investment project.
The accounting rate of return
The accounting rate of return also referred to as the return on investment method calculates the estimated general profit or loss concerning an investment project and connects that profit or loss to the amount of capital injected in the project as well as the period for which that investment is required to go. The profit referred to in the appraisal process here is the one that is directly linked to the investment project and, therefore, costs or revenues made elsewhere in the business are not included. There is a minimum rate of return required for any investment that a business wants to undertake. This is connected to the business’s cost of capital. If an investment results into a return that is greater than the related cost of capital, then it would be considered appropriate and profitable. The formula for calculating the accounting rate of return is as follows:
Accounting rate of return=Average rate of return = average yearly profit/average investment x 100% (Rohrich, 2007).
The average yearly profit is found by adding the annual profits for the years of life of the investment project and dividing the total life of the investment project in years and the average investment is found by adding the investment in the first year to the remaining value at the end of life of the project and dividing by two. With these two values, we can comfortably calculate the ARR. This calculation gives the uniqueness of product as well as its drawbacks as we can see in the subsequent discussions and comparisons.
The main advantages of accounting rate of return are:
Accounting rate of return considers the general profitability of the investment project.
The method is simple to understand as well as easy to use.
The method’s end outcome is expressed in form of a percentage, permitting projects of varying sizes to be compared.
The major drawback is:
The method is based on the accounting profits and not the cash flows. Calculation of profit as well as capital employed is based on expenditure items, which are treated as revenue (those appearing on the profit & loss account) and as capital (appearing on the balance sheet). Even though there are guidelines relating to this area, this practice can be quite subjective. Various accounting policies, for instance, relating to depreciation can generate different figures of profit and capital employed, therefore permitting the profit as well as balance sheet numbers to be manipulated in some way. This is why capital projects are also appraised in terms of cash flows.
Accounting rate of return method does not consider the timing of cash flows of the project. For instance, we may have two projects M, and N. Project M may result in an accounting rate of return of 19 percent whereas project N may have ARR of 17 percent. Nevertheless, investment M may be a six year investment whilst investment N may be a four year investment. Project N will likely be preferred to project M by investors since they want a project that generates cash earlier even if it is slightly less profitable (Rohrich, 2007).
The accounting rate of return does not consider the “time value of money”. A seven percent return on a capital investment project of $ 35, 000 m might be okay; nevertheless it may not be good enough return where the initial investment was $ 100 billion.
The payback method
The payback technique is an investment appraisal method that seeks to answer the question of how long it would take to get the money invested back. This is the time it will take for the cash flows coming from the project to accurately equal the investment amount. In terms of comparing projects, the pay back method is concerned with how fast this will happen. It is an easy method that is commonly applied in businesses and it is based on concern of the management to get repaid on the initial investment outlay as fast as can happen. The payback method is not concerned with the general profitability or profitability level (Lumby, 1988).
Using the method a business will just reject an investment project that has a payback period exceeding the required. The main advantages accorded to payback include:
Being simple to understand as well as apply, and the fact that it promotes caution as a policy in investment.
However, it also has drawbacks as follows:
Payback does not consider timing of cash flows ($200 received now cannot have the same value as $200 received in a year). In other words, time value of money is not considered.
Payback is only concerned with how faster the initial investment is repaid and therefore it neglects the general profitability of the investment.
The following method solves the aspect of time value of money that proves a challenge to the first two methods of investment appraisal.
The Net Present Value (NPV)
The Net Present Value (NPV) method involves discounting of the entire inflows and outflows of a capital investment at a selected aimed cost of capital or rate of return. An investment projected is accepted when it gives a positive NPV. A positive NPV means the project is expected to be profitable. On the other hand, a project with a negative NPV is rejected as it is expected to be unprofitable (Lumby & Jones, 2001).
The main advantages of NPV method are:
The method considers the “time value of money”. With NPV, profit and the problems related to profit measurement are debarred. Use of cash flows gives emphasis to the importance of liquidity, and finally it is simple to compare different projects’ NPV.
The main drawback of this method is that understanding it is not as easy as it is for accounting rate of return and payback. Besides, the NPV method requires knowledge of the cost of capital of a company, which is not easy to calculate.
The Internal rate of return (IRR)
The fourth method of investment appraisal is the IRR method. Internal rate of return calculates the precise rate of return that the investment project is expected to attain based on the estimated cash flows. The discount factor that will result in an NPV of zero is the IRR. It is the return a company gets from a project, after considering the “time value of money”. In decision making, you accept an investment project if the IRR of the project is greater than the related cost of capital. The main advantage associated with the IRR method is that the information it gives is better understood by managers, particularly non-financial managers (Lumby & Jones, 2003). However, it has the following disadvantages:
There is a possibility of calculating more than two dissimilar IRRs for an investment project. This happens where the cash flows throughout the project’s life are a mixture of negative and positive values. This means when this situation happens, then it is not easy to recognize the real IRR and it is advisable to avoid the IRR method.
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