Investment Appraisal Techniques

Investment Appraisal Techniques

Investment appraisal techniques are payback period, internal rate of return, net present value, accounting rate of return, and profitability index. They are primarily meant to appraise the performance of a new project. The first question that comes to our mind before beginning any new project is “Whether it is viable or profitable? These techniques answer this question very well. Each technique evaluates the project from a different angle and provides a different insight. Let us understand these techniques in brief.

Payback Period

One of the simplest investment appraisal techniques is the payback period. Payback technique states how long does it take for the project to generate sufficient cash-flow to cover the initial cost of the project.

For Example,

XYZ Inc. is considering buying a machine costing $100,000. There are two options Machine A and Machine B. Machine A will generate revenue of $ 50,000, $ 50,000 & $ 20,000 in year 1, year 2 & year 3 respectively. Machine B will generate revenue of $ 30,000, $ 40,000 & $ 60,000 in year 1, year 2 & year 3 respectively.

As per above example payback period is 2 years & 2.5 years for machine A & machine B respectively. According to the payback period method, machine A will be given preference.

The advantage of payback is, it is very easy to calculate & understand. Even people not from finance background can easily understand it. But the disadvantage is that it ignores the time value of money & anything that happens after a payback point.

Accounting Rate of Return Method

Accounting rate of return is an accounting technique to measure profit expected from an investment. It expresses the net accounting profit arising from the investment as a percentage of that capital investment. It is also known as return on investment or return on capital.

The formula of ARR is as follows:

ARR=(Average annual profit after tax / Initial investment) X 100

For Example,

XYZ Inc. is looking to invest in some machinery to replace its current malfunctioning one. The new machine, which costs $ 420,000, would increase annual revenue by $ 200,000 and annual expense by $ 50,000. The machine is estimated to have a useful life of 12 years.

• Depreciation expense per year = $ 420,000/ 12 = $ 35,000
• Increase in average annual profit = $ 200,000 – ( $ 50,000 + $ 35,000) = $ 115,000
• Initial investment = $ 420,000
• ARR = ( $ 115,000 / $ 420,000 ) * 100 = 27.38%

Net Present Value

It is the most common method of investment appraisal. Net present value is the sum of discounted future cash inflow & outflow related to the project. Generally, the weighted average cost of capital (WACC) is the discounting factor for future cash-flows in net present value method.

In essence, this method sums up the discounted net cash flows from the investment by the minimum required rate of return & deducts initial investment to give the ‘net present value’. The company should accept the project if the NPV is positive.

The formula of NPV ={ [CFi/(1+i)¹]+ [CFi/ (1+i)²] + [CFiii/(1+i)³] …….. [CFn/(1+i)ⁿ]} – Initial Investment

Where,

CFi = Cash-flow of first period

CFii = Cash-flow of second period

CFiii = Cash-flow of third period

CFn = Cash-flow of nth period

n = No. of Periods

i = Discounting rate

For Example,

XYZ Inc. is starting the project at cost of $ 100,000. The project will generate cash-flow of $ 40,000 , $ 50,000 & $ 50,000 in year 1, year 2 & year 3 respectively. Company’s WACC is 10%. Find out NPV.

Formula of NPV    =   [ $40,000/( 1+0.1)¹] + [ $ 50,000 / (1+0.1)² ]   +[ $ 50,000/ (1+0.1)³ ]   – 100,000

Net present value = $ 36,363.63 + $ 41,322.31 +$ 37,565.74 – $ 100,000

= $ 115,251.68 – $ 100,000

The net present value of the project is $ 15,251.68.

Here, the net present value of the project is positive & therefore the project should be accepted.

Internal Rate of Return Method

An internal rate of return is the discounting rate, which brings discounted future cash flow at par with the initial investment. In other words, it is the discounting rate at which the company will neither make loss nor make a profit.

It is obtained by trial & error method. We can also state that IRR is the rate at which the NPV of the project will be zero. i.e. Present value of cash inflow – Present value of cash outflow = zero

Profitability Index

Profitability index defines how much you will earn per dollar of investment. The present value of an anticipated future cash flow divided by initial outflow gives the profitability index (PI) of the project. It is also one of the easy investment appraisal technique.

Suppose, the present value of anticipated future cash flow is $ 120,000 & Initial outflow is $ 100,000. Then the profitability index is 1.2. i.e. $ 120,000 / $ 100,000. Which means each invested dollar is generating revenue of 1.2 dollars. If the profitability index is more than 1, the project should be accepted & if it is less than 1 it should be rejected.

If we reduce complication, it is nothing but a different presentation of NPV.

Discounted Payback Period Method

This method is the same as the payback period method. The only difference is, in discounting payback method is that payback period is calculated on the basis of discounted future cash-flows while in payback method it is calculated on the basis of future cash-flows.^1,