Atrill & McLaney (2011, p.358) describe the four main methods of investment appraisal to be:
1) Accounting Rate of Return (ARR)
2) Payback Period (PP)
3) Net Present Value (NPV)
4) Internal Rate of Return (IRR)
It is noted that companies do have variations on the above but these are the main methods used. Details of the four methods are as follows:
1) Accounting Rate of Return
Atrill & McLaney (2011, p.359) explain the ARR method to use the two main pieces of information.
- Annual average operating profit
- Average investment
The equation to calculate the ARR is as follows:
ARR = Annual average operating profit / Average investment (to achieve profit) x 100%
The company should decide a minimum target ARR and base their decisions upon projects achieving an ARR of that minimum percentage or higher. If there are numerous projects that meet the required minimum, the one with the highest ARR should be selected (Atrill & McLaney, 2011, p.360).
The main risk with using ARR is that it does not take into consideration the time factor for return on investment (Atrill & McLaney, 2011, p.362). If three projects have an equal investment and projected return a fixed period of time, they will all have the same ARR; but if one of those projects covers its investment costs within 1 year and the other only after 4 years, project 1 should be the clear winner.
The second major flaw in the ARR method is that ARR is based on Accounting profits rather than cash profits. As explained in an example by Atrill & McLaney (2011, p.362); if an asset has a residual value at the end of life of the project, giving it away rather than selling it allows for a higher ARR (Average Investment = Cost of Asset + Residual Value).
2) Payback Period
This calculates the amount of time that is required for a project to repay the initial investment amount out of its resulting cash inflow (Atrill & McLaney, 2011, p.364).
Companies should base their decisions when using PP on a predefined maximum time limit for projects to repay their investments, the project with the shortest projected time to repay initial investment should be chosen (Atrill & McLaney, 2011).
The flaw with this method is that it doesn’t consider the amount of cash flow in the period it takes to repay the investment. As per Atrill & McLaney’s example (2011, p.366) if project A B and C repay an investment in the exact same amount of time (3.5 years), but project C repays almost all of the investment in the first year while project B and A in the late 2nd and 3rd respectively, project C should be the clear winner. Also, it does not consider the cash flows after the initial investment has been reach, it concentrates on high initial returns which lends itself to a more negative idea that the project is going to fail so the money must be recouped as soon as possible. If project A gives twice as much return as project C after the third year then that should be strongly considered as a better option.
3) Net Present Value
The NPV method allows us to make a decision based on all of the costs and benefits as well as the exact timings in which they occur (Atrill & McLaney, 2011, p.368).
To put it simply, NPV compares the value of the invested currency today and compares it with the value of that invested currency in the future, also taking into consideration inflation and returns (Investopedia, 2011).
Value Based Management (n.d.) describes the steps to calculating NPV as follows:
1) Calculate expected free cash flows per year as a result of the investment
2) “Subtract/discount for the cost of capital (an interest rate to adjust for time and risk)”
This intermediate result is called the Present Value
3) Subtract initial investment amounts
This end result is the Net Present Value
Companies should consider projects with a positive NPV, negative NPV’s should be rejected and the project with the highest positive NPV should be chosen when faced with multiple projects.
The problem with NPV as explained by Value Based Management (n.d.) is that it does not account for flexibility or changes / uncertainty after the decision has been made to proceed with the project.
4) Internal Rate of Return
This method is closely tied with NPV. IRR uses the method of discounting future cash flows from an investment but it produces the discount rate at which an NPV value of zero is achieved (Atrill & McLaney, 2011, p.379). It is noted that IRR is difficult to calculate as it involves trial and error to get the value down to 0.
IRR can be thought of as “the rate of growth a project is expected to generate” (Investopedia, n.d.).
Investopedia (n.d.) explains that generally a project with a higher percentage IRR is more desirable than one with a lower percentage IRR. The project that yields the highest percentage IRR is the project that should be considered first.
The flaw with IRR is that it does not take into consideration the scale of development (Atrill & McLaney, 2011, p.383), basically an increase in investment can increase returns yet give us the same percentage. Another issue is that it does not cater for fluctuations in cash flows. With a fluctuating cash flow, multiple IRR’s or none at all may be the result (Atrill & McLaney, 2011).
Atrill & McLaney (2011, p.383) mention that NPV overcomes the flaws of IRR and out of the 4 options outlined above I would also tend to lean towards NPV as being the best method of assessing a risky investment because it gives us closer to real world values of our returns on a project. I believe it is very important to consider that even if we are getting a positive return when projecting, what would that amount really equate to in the time frame that it is being returned, with inflation and rising labour costs it wouldn’t be wise to exclude them from your assessments.
That being said, as Atrill & McLaney (2011, p.388) point out, companies use combinations of the above 4 methods to evaluate investments and I would consider using NPV and IRR and PP when considering an investment.
References
Atrill, P. & McLaney, E. (2011) Accounting and Finance for Non-Specialists. 7th Edition. Prentice Hall.
Investopedia (n.d.) Internal Rate of Return – IRR [Online]. Available from: http://www.investopedia.com/terms/i/irr.asp (Accessed:
Investopedia (n.d.) Net Present Value – NPV [Online]. Available from: http://www.investopedia.com/terms/n/npv.asp (Accessed: 30 April 2011).
Value Based Management (n.d.) Net Present Value Method [Online]. Available from: http://www.valuebasedmanagement.net/methods_npv.html (Accessed: 30 April 2011).