Investment appraisal techniques
There are numerous ways through which a business can carry out investment appraisals, but here are three of the most common techniques:
Payback period is the length of time between making an investment and the time at which that investment has broken even.
To calculate the payback period, you’d take the cost of the investment and divide it by the annual cash flow. Investments with shorter payback periods are more desirable because it will take less time for an investor to receive back their capital.
Net present value
Net present value (NPV) is the difference between the current value of cash inflows and the current value of cash outflows over a determined length of time. NPV is used to calculate the estimated profitability of a project and it is a form of capital budgeting which accounts for the time value of money.
The time value of money is the principle that money is worth more in the present than an equivalent amount will be in the future because it has longer to earn interest. Cash inflows and outflows are adjusted according to the principle of the time value of money, taking available interest rates into account.
As a result, NPV determines whether it is more financially prudent to invest in a project, or to accept a different rate of return elsewhere based on projected future returns. To calculate the NPV, you would subtract the current value of invested cash from the current value of the expected cash flows.
If the NPV is positive, then it indicates that a project’s predicted earnings or profits are greater than the anticipated costs. If the NPV is negative, then the reverse is true, and the project or investment might not be pursued by the company.
Accounting rate of return
The accounting rate of return (ARR) is a ratio used in capital budgeting to calculate an investment’s expected return compared to the initial cost. Unlike NPV, ARR does not account for the time value of money, and if the ARR is equal to or greater than the required rate of return, then the project is deemed to have acceptable levels of profitability.
ARR is presented as a percentage return, meaning that an ARR of 20% means that the project is forecast to return 20p for every 100p invested over a one-year period. To calculate the ARR, you would divide the average return during a given period by the average investment in that same period.