The investment appraisal techniques are very important to every company and individual when allocating resources to capital projects. Investment appraisal techniques help to evaluate the cost and benefits of capital investment. There are many methods of evaluating investment proposals. These methods are majorly categorized into two; traditional methods such as payback period and accounting rate of return as well as a modern or discounted method such as net present value and internal rate of return.
Investment Appraisal methods
This investment appraisal method considers the time it takes a company to recoup its initial capital outlay. It is the period for the cash inflows from a capital project to equal the project’s cash outflows. i.e. it is the number of years it takes a project to pay back the cost of investment.
However, it is the first screening method of capital projects. The shorter the payback period of a project, the better for the project. When a company has to choose between two mutually exclusive projects, the project with the shortest payback period will be selected. The method is very simple as well as easy to understand. But, it fails to consider the time value of money as well as cashflows after the payback period in the evaluation.
Accounting rate of return
This is another investment appraisal method. This is also known as return on capital employed or return on investment. This method involves calculating the return to be generated from the investment by dividing the net income by the average or initial investment in the project. When choosing between exclusive investments, the one with higher ARR will be selected. The ARR of an investment is compared with the company’s arbitrary target to determine whether to accept or reject the project. So, the higher the ARR of a capital project, the more attractive the project will be.
However, the method is easy to calculate as well as simple to understand. It makes use of accounting profit throughout the lifespan of the project. But, ARR fails to consider the time value of money. Also, it makes use of many concepts in determining the accounting rate of return. In calculating ARR, the formula is thus:
Net present value
This method involves the calculation of net present value (NPV) to determine the viability of the investments. NPV is calculated by discounting all the estimated cash inflows and cash outflows of the project using appropriate rates such as weighted average cost of capital. This method considers the time value of money in appraising investment. Also, it considers the cash flows throughout the lifespan of a project.
Since the company’s objective is to increase shareholders’ wealth, any project with a positive NPV is worthwhile. Any project with a negative NPV is unacceptable. When choosing between different exclusive investments, the project with a higher NPV will be selected. However, it is difficult to calculate and understand. The formula to calculate NPV is as thus:
r is the rate of interest, while n is the number of years.
Internal rate of return
This is the rate of return that equates the initial capital invested on a project to its estimated cash inflows. So, it is the rate at which the difference between cash outflows and cash inflows of the investment is equal to zero. i.e. rate at which NPV is 0. However, the internal rate of return (IRR) is usually used jointly with NPV. The higher the investment’s IRR, the more attractive the project will be. IRR is calculated using the trial and error method. The formula to calculate IRR is as thus:
A represents the lower rate of return that gives positive NPV
B represents a higher rate of return that gives negative NPV
P represents positive NPV N represents Negative NPV
Which investment appraisal technique is the best?
Each investment appraisal technique has its advantages and disadvantages. So, you should use a combination of these methods when assessing the viability of capital investment. However, assessing projects using the investment appraisal technique is a quantitative assessment, you should also consider a qualitative assessment.
Afeez is one of the founding partners of Marasas Consulting limited. He consults for both individuals and entities in the area of accounting, management, audit, tax, and investment. He has a wide range of experience both online and offline which allows him to provide relevant and timely professional advice and assistance to business owners with their accounting, tax, management, audit, and investment plans.
Afeez is a member of the Institute of Chartered Accountants of Nigeria (ICAN) and a member of the Nigerian Institute of Management (Chartered). He is a certified Google analyst and strategist. He earned his Bachelor degree in Management and Accounting from Obafemi Awolowo University, Ile-Ife, Nigeria, and earned an ordinary national diploma in Accountancy from The Polytechnic of Ibadan, Oyo State, Nigeria. He earned certification in “Excel Crash Course” and “Reading of Financial Statement” from Corporate Finance Institute, Canada.
Afeez is dedicated to helping clients achieve business success by helping them to establish solid and sound accounting, tax, and financial processes.