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Introduction

Business entities are set up to deliver value to the society while gain profits in return for their products and services. In the process of delivering products or services to the society, businesses are required to make capital investment before future benefits can be realized. The capital investment decisions are critical to the survival as well as profitability of a firm. As such, various capital investment appraisal techniques or methodologies should be applied to analyzed and evaluate the attractiveness of a capital investment, before the management commit huge sum of capital into a single project or line of business.

There are many investment appraisal techniques commonly used by management in real-life to evaluate potential projects. Each of the techniques has its own advantages, disadvantages and applications. Specifically, different methods should be used or applied in different context, or when the management has different objectives. Thus, a study and understanding of the various investment appraisal techniques is important and critical, for management to understand the pros and cons of each technique, and the relevance of these techniques in a particular situation.

The following part will discuss three types of investment appraisal techniques, namely, (1) the Accounting Rate of Return, (2) the Payback Methods, and (3) the Net Present Value Method. For each of these investment appraisal methods, its relative functions, applications, advantages and disadvantages will be discussed in details in the following sections.

Description and Critical Evaluation of Accounting Rate of Return (ARR)

The accounting rate of return (hereby abbreviated as ARR) is a very simple type of rate of return calculation. It can be calculated by dividing average profit by average investment (i.e., the average here means the arithmetic mean for profit and amount of investment). In calculation of ARR, generally, the profit figure used is often referred to the concept of operating profit (for a particular project).On the other hand, the average investment is referred to as the book value of assets used up (in the particular project). The calculation of ARR recognized the concept of depreciation and amortization (i.e., employing the accounting concept). Thus, the profit figure used is after depreciation and amortization, and the value of assets used is also after depreciation and amortization.

Typically, the concept of ARR is most often applied in a business unit or department when management desire to select alternatives among projects. Sometimes, it is also used to judge the performance of various projects and subsidiaries within a company.

Limitations of ARR. However, ARR has many limitations in practice. Perhaps the main weakness is that ARR is overly simple. Besides, this measure is also rarely used by investors (perhaps should not be used at all), because of these reasons: (1) cash flows are critically important to investors, but ARR is based on numbers that include non-cash charges (such as depreciation and amortization), (2) ARR never consider the time value of money (i.e., technically speaking, the value of cash flows does not diminish with time as is the case for NPV and IRR calculation), (3) ARR does not associates or considers the fact that greater risk is incurred due to longer term forecasts, and (4) there are many other investment appraisal methodologies which are not very difficult to calculate (but do consider many other aspects on risk, time value of money and etc.). Thirdly, because ARR does not consider the time value of money, and also because it is entirely unadjusted for non-cash charges such as depreciation, to use ARR in selecting investments is seriously flawed. In many instances where the results generated from ARR conflicted with the results indicated by NPV, the outcome of NPV is generally a correct and a better one because NPV does consider time value of money as well as dealing with net cash flow – an important criteria preferred and focused by investors.

Advantages of ARR. Perhaps the most striking advantage of ARR is that it is very easy to calculate, and the concept is simple and easy to understand.

Description and Critical Evaluation of Payback Method

The payback period (PBP) is the number of years it takes to recover the initial cost of an investment. The calculation of payback period can be performed with the usage of a cumulative net cash flow table. For example, referring to the table below:

The payback period can be determined from the cumulative net cash flow table as follow:

Payback period = years until full recovery + (unrecovered cost at the beginning of the last year/ cash flow during the last year)

Decision rules for Payback Period. Generally speaking, the shorter a project’s payback, the better. To decide which projects to accept, the company must first establish a benchmark payback period. If payback period is less than the benchmark payback, manager should accept the project. In contrast, if payback period is higher than the benchmark payback, then the project should be rejected.

Limitations of Payback Period. The main drawback of the payback period is that it ignores the time value of money. The payback period ignores cash flow beyond the payback period. This means terminal or salvage value wouldn’t be considered.

Advantages of the Payback Period. The main benefit of the payback period is that it is a good measure of project liquidity and riskiness. Such a measure also offers another perspective to investors to judge how fast they can recoup their original investment back.

Description and Critical Evaluation of NPV

The net present value method (NPV) relies on discounted cash flow (DCF) analysis. The first step in NPV analysis is to find the present value of each cash flow discounted at the project’s cost of capital. This assumes that the cost of capital has been adjusted for risk. To compute NPV, we need to sum up all of the discounted cash flows. The formula is as follow:

The NPV is the amount of cash flow (in present value terms) the project generated after repaying the interested capital (project cost) and paying the required rate of return on that capital. A positive NPV project increases shareholder wealth, while a negative NPV project decreases shareholder wealth, and a zero NPV project has no effect on shareholder wealth.

Decision rules for NPV. For independent projects, the NPV decision rule is to accept the project as long as the NPV is positive. For mutually exclusive projects, the manager should choose the one with the highest NPV project (subject to the condition that the NPV is zero or greater.).

Drawbacks of the NPV method. Its main weakness is that it does not measure the size of the project, just the size of the return. For example, an NPV that equals to $100 is great for a project costing $100 but not so great for a project costing $1 million.

Advantage of NPV method. A main advantage of NPV is that it is a direct measure of the dollar benefit of the project to the shareholder. The measure is very popular used and widely accepted. The measure also considers the riskiness of project, with the measure of cost of capital. Besides, it also considers the time value of money for a project. NPV is considered the best measure. The NPV method is considered the best method since it leads to conceptually correct capital budgeting decisions.

Conclusion

In short, different investment appraisal methods have different functions, application, advantages, and disadvantages. In fact, various methodologies are designed to evaluate an investment options from different perspective and dimensions, so that these appraisal methods can tell different information to the management.

Perhaps all these investment appraisal methods can be categorized as those that consider the impact of time value of money, such as the NPV and IRR method, and those that never consider the time value of money, such as the payback methods as well as the ARR method. Obviously for long term projects, the consideration of time value of money is critical and essential, and thus methodologies such as NPV and IRR is more relevant. However, for short term projects (i.e., usually defined as lesser than 1 year), the usage of methods such as the payback method and ARR may be acceptable.

However, each methods has own key advantages and deliver different key information to the management. For example, both the NPV and IRR methods are useful in deciding whether a projects can yields sufficient returns relative to the investment in the traded financial securities. From the other perspective, the payback method can reveal the risk level from a liquidity perspective of a firm.

Nonetheless, the NPV method is considered as superior to other methods. It is superior to the IRR method because the IRR method cannot reliably used to correctly judge mutually exclusive projects. Besides, another criticism on the IRR is that the IRR methods make incorrect or heroic reinvestment assumptions, where all the interim cash flows are assumed to be reinvented at the IRR rate. Apart from that, multiple IRR issues may also present in certain cases. If the NPV method is compared to other methods such as the ARR and the payback method, it is superior because the NPV method explicitly considers the time value of money. As conclusion, generally, the NPV method is sufficiently good enough for investment appraisal of alternatives projects, while the other methods are useful also, in the sense that these methods can supplement the NPV methods (by providing more information from various dimensions) in decision making.

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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