Introduction

In running a business, investor and management alike are facing many capital investment alternatives or options. In this context, the term capital investment is used to refer to the investment outlay in the present time to yield a stream of investment returns in the future. There may be both short term and long term capital investment decisions to be made by the management. However, those long terms capital investment decisions are more impactful to the future performance or profitability of a company, and deserved much more attention from the management.

In real-life, the commitment of capital on a long term basis involves the element of interest cost (due to the component of inflation and risk-free-rate) that should be taken into account in evaluating the feasibility or viability of a project or business proposal. In this writing, the concept of interest costs to a investment decision is defined as the time value of money.

There are a variety of investment appraisals techniques developed and designed to assist managers to evaluate the attractiveness and expected profitability of a particular capital investment opportunity. Some of these techniques are developed in a way that able to take the effect of time value of money into consideration, while the other investment appraisal techniques do not consider the effect due to time value of money.

In the following section, three of the investment appraisal techniques will be discussed. The respective calculation, functions, objectives, benefits, and limitations will be outlined so we can compared the differences and uniqueness of each methods.

Accounting Rate of Return

Generally, the accounting rate of return is usually defined as the ratio of ‘accounting profit’ to the ‘total capital employed’. It is often calculated before the tax figure and the interest charges. The ratio is often measured and calculated for a certain time frame.

Applications and usage. The accounting rate of return is practical and widely used (both in business world and in business school) because the method provides a sound basis (i.e., theoretically logical and reasonable) for comparison of profitability and risk aspects for various investment alternatives. In the context of capital budgeting, where managers are concern to evaluate the viability of a business plan or capital investment decisions, the accounting rate of return is also frequently employed by organizations to decide and choose among several competing projects. In such a situation, the objective is to choose the project with the highest reward-to-risk ratio (i.e., projects with maximum reward while at the same time with minimum risk relative the other alternatives). The formula for accounting rate of return is often cited as follow:

Advantages of accounting rate of return. Accounting rate of return is a practical and useful ratio for manager to compare alternative projects. By comparing the expected accounting rate of return for the various alternative investment opportunities under consideration, a firm can determine which option would offer the best financial return on investment. In fact, it is also often argued that after the decision is made, the firm can employ the accounting rate of return techniques to follow up the profitability and cost savings achieved from the capital investment (decisions). This is very important, because the ratio can then assist the firm to plan, control and manage more effectively, while at the same time to improve accuracy of future decision making in terms of capital expenditures. Apart form that, the accounting rate of return is also a relatively simple techniques. As it is a simple and easy formula, it is useful as quick estimates, allowing management to make fast decision and to take advantage of sudden opportunities. It cannot be denied that the accounting rate of return method offers unique benefits and advantages to business owners or management, by suggesting a useful, practical and relatively easy way to compare different capital expenditures options, thus allowing the management to respond rapidly to opportunities when they arise.

Disadvantages of accounting rate of return. Although the concept of accounting rate of return is practical, useful and helpful, it is used less frequent because the method does not factor in the time value of money. In other words, this means that it fails to consider the likely return on capital invested via normal means. Additionally, the accounting rate of return method uses the accounting income data (i.e., the use of accounting income) rather than the cash flow information. The application of accounting income in this ratio cause several drawbacks to the ratio. It is often cited that such an issue limits the ratio accuracy for capital investments with high upkeep or those projects with high maintenance costs.

Payback Period

Payback Period calculation is perhaps the simplest ratio to evaluate alternatives of investment projects. With this ratio, investors can be informed on the time needed in recouping the cost of initial investments. The term payback period is referring to the amount of time that is required for a capital budgeting project to recover its initial investment amount. On a more technical term, the payback period can be defined as the expected length/ amount of time that is needed for a project to recoup its initial investment outlay, from the cash returns generated after implementation of the project. This period is also usually referred to as the time that it takes for an investment to pay for itself.

The core idea of the payback method is that the sooner the cost of an investment can be recouped or recovered, the less risky (i.e., better) is the investment. The following formula is often applied to calculate the payback period.

Advantages of Payback Period Method. Under certain situation or circumstances, the concept of payback method can be very useful. The first advantage of this method is that it can help management in screening of investment proposals. For example, if an investment option does not provide a payback within some desired or even required benchmark time period, then the usage of payback period can screen out those undesired investment options very fast.

In some special cases, the method can have high value as compared to other ratio. For example, the payback period is often critically vital to new or smaller size company that is facing tight cash flow issues. It is also reasonable to understand that when a firm is cash poor or having some liquidity problems, those projects with a short payback period (i.e., less risky from a liquidity standpoint) but a low rate of return should be preferred over other projects with long payback periods, although the other projects may come with a high rate of return. In terms of working capital management, the company may simply need a faster and sooner return of its cash investment to reduce risk. Another example is that, the payback method is sometimes helpful and practical in industries where products or services become outdated or obsolete very fast. Since the products may last for a short period of time, the payback period on investments to be chosen should be relatively short as the risk of insolvency is managed properly.

Disadvantages of payback period. The method has several limitations. Firstly, it is not useful for very long financing. It ignores any benefits that occur after the payback period and, therefore, the ratio in fact does not measure profitability. The ratio place more importance on the measure of risk. Then, some also critique that the method doesn’t take the impacts due to time value of money into considerations, so very often companies may have to pay more than they actually acquire (i.e., a company may even taking up a negative NPV project if the decision is made purely using the payback method). The payback period method is also criticized to having limitations with Inflation as well. As it is know that the rise of inflation can cause serious damage to organization’s finance, the impacts due to inflation should never be neglected by a firm. Because of these reasons, other methods of capital budgeting like NPV, IRR or DCF are generally a more preferred method.

NPV

Net present value (NPV) is also often known as the net present worth method. It is defined or calculated as the total present value of a time series of future cash flows. It is a standard technique commonly applied in using the concept of time value of money to appraise long-term projects in capital budgeting. Besides it is widely used for capital budgeting, and widely recognized throughout the field of investment or economics, it can also applied to measure the excess or shortfall of cash flows (in present value terms) once the financing charges (such as interest costs) are met.

In the NPV model it is assumed that all the interim cash flows are to be reinvested at the discount rate used. This is assumption appropriate in the absence of capital rationing. Today, the NPV method is the most widely accepted and applied mathematical tool for analyzing capital investment projects, primarily because such method takes into account the impacts from time value of money.

Advantages of the NPV method. With the NPV method, the main advantage is that the method able to generate a result which is sufficiently reliable and good to act as a direct measure of the dollar contribution to the stockholders’ wealth. Besides, as will be discussed in the conclusion, when comparing to other investment appraisal methods, NPV method is superior to many other ratios or method used to evaluate investment opportunities.

Disadvantages of the NPV method. There are several limitations of the NPV method as well. For example, one often cited drawback of this method is about the adding of risk premium to the discount rate (for adjustment of risk) can inaccurately or artificially make the cost higher. Secondly, it is also argued that when the risk premium is incorporated into the discount rate, due to the compounding effects from the extra risk premium, such compounding effects can results in a very low NPV.

Conclusion

In the section above, it is discussed several techniques of investment appraisal method to evaluate different capital investment decisions. It is discussed and noted that each and every investment appraisal techniques comes with its own function, benefits and limitations. The various techniques have different usage and can deliver different value to the decision makers or managers in a different setting. Thus, it is very important for a manager to understand these techniques in and out so that they know when the right time to apply these techniques is.

Generally, from various literature review and academic business textbooks, it is found that the NPV method is cited as the best investment appraisal techniques up-to-date. There are many reasons. Firstly, the method is practical and reflective of the real return from investment, because it directly incorporates the time value of money effects into its calculation. In contrast, methods such as the payback method or the accounting rate of return method do not take the effects due to time value of money into account. When compared to the IRR method (where IRR method does take the time value of money effects into consideration), the NPV method is still superior because NPV method can be used to correctly evaluate mutually exclusive projects while IRR may not be relevant. Besides, the IRR method has several limitations as well. Firstly, it has the multiple IRR issues. Secondly, it incorrectly assumes that all the interim cash flows are to be reinvested at the IRR rate (when the discount rate used in NPV analysis is more relevant).

References

Robert N Anthony, David F Hawkins and Kenneth A Merchant (1999). Accounting: Text and Cases, 10^th international edition, McGraw-Hill.

John J. Wild (2000). Financial Accounting-Information for decision, McGraw-Hill

Weygandt, J., Kiero, D., and Kimmel, P. (1998). Financial Accounting, 3/e, John Wiley

Meigs, R., Williams, J., Haka, S. and Bettner, M. (1999). Accounting: The Basis For Business Decisions, 11/e, McGraw-Hill

Warren, C. S., Reeve, J. M., and Fess, P. E. (1999). Accounting, 19/e, International Thomas Publishing

Skousen, K., Albricht, W., Stice, J. Stice, E. and Swain, M. (1998). Accounting: Concepts and Applications, 7/e, International Thomson Publishing

Horngen, H. and Izan, B. F. (1997). Accounting, 2/e, Prentice Hall.

Reilly, F. K. and Brown, K. C. (2003). Investment Analysis and Portfolio Management (7^th edition). International Thomson Publishing.

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