As capital investment decisions usually involve significant amounts of finance, it is important to fully evaluate each decision using sound appraisal techniques.  The main methods used to evaluate investment in capital projects are:

• Accounting rate of return.
• Payback method.
• Net present value.
• Internal rate of return

These methods use different approaches to evaluating the value of an investment for an organisation.  While three of the methods focus on cash flow, the accounting rate of return uses accounting profit in its appraisal calculation, providing a view of the overall profitability of the investment.

The accounting rate of return method calculates the estimated overall profit or loss on an investment project and relates that profit to the amount of capital invested and to the period for which it is required. It is the profit that is directly related to the investment project that is used in the appraisal process and thus costs or revenues generated elsewhere in the business are excluded. A business will have a required minimum rate of return for any investment. This is related to the cost of capital of the business. If an investment yields a return greater than the cost of capital, then the investment would be considered suitable and profitable. The accounting rate of return is an average rate of return calculated by expressing average annual profit as a percentage of the average value of the investment.

Its main advantages are

q     It takes account of the overall profitability of the project.

q     It is simple to understand and easy to use.

q     Its end result is expressed as a percentage, allowing projects of differing sizes to be compared.

Its main disadvantages are

q     It is based on accounting profits rather than cash flows. The calculation of profit and capital employed depend on which items of expenditure are treated as capital (on the balance sheet) and as revenue (charged to the profit and loss account). Despite guidelines in this area, it can be quite subjective. Also different accounting policies (depreciation) can produce different profit and capital employed figures, thus allowing the profit and balance sheet figures to be somewhat manipulated. It is for this reason that capital projects are also evaluated in terms of cash flows.

q     The ARR does not take into account the timing of cash flows. For example, project A may give an ARR of 20 per cent compared to project B’s 18 per cent. However project A may be an eight year project whereas project B may be a five year project. Investors may choose a project that is slightly less profitable but which generates cash earlier.

q     The ARR does not take into account the time value of money. It does not take into account the cost of waiting to recoup the investment. 

q     The ARR takes no account of the size of the initial investment. A five per cent return on an investment of €25,000 might be acceptable, however it may not be an acceptable return on an initial investment of €10 million.

The payback method of investment appraisal simply asks the question ‘how long before I get my money back?’ In other words how quickly will the cash flows arising from the project exactly equal the amount of the investment. It is a simple method, widely used in industry and is based on management’s concern to be reimbursed on the initial outlay as soon as possible. It is not concerned with overall profitability or the level of profitability.

Based on this method a business will simply reject a project with a payback period longer than that required. The advantages of payback are

q     It is simple to understand and apply.

q     It promotes a policy of caution in investment.

Its main disadvantages are

q     It takes no account of the timing of cash flows (€100 received today is worth more than €100 received in 12 months time). This is known as the time value of money and will be considered in more detail below.

q     It is only concerned with how quickly the initial investment is recovered and thus it ignores the overall profitability and return on capital for the whole project.  The accounting rate of return incorporates the overall profitability of the investment.

The net present value approach involves discounting all cash outflows and inflows of a capital investment project at a chosen target rate of return or cost of capital. The present value of the cash inflows minus the present value of the cash outflows is the net present value. If the NPV is positive, the project is likely to be profitable, whereas if the NPV is negative, the project is likely to be unprofitable. Its main advantages are

q     It takes into account the time value of money.

q     Profit and the difficulties of profit measurement are excluded.

q     Using cash flows emphasises the importance of liquidity.

q     It is easy to compare the NPV of different projects.

The main disadvantage associated with this method is that it is not as easily understood as the payback and accounting rate of return. Also, the net present value approach requires knowledge of the company’s cost of capital, which is difficult to calculate.

The IRR method calculates the exact rate of return which the project is expected to achieve based on the projected cash flows. The IRR is the discount factor which will have the effect of producing a NPV of 0. It is the return from the project, taking into account the time value of money. Its decision rule is to accept the project if it’s IRR is greater than the cost of capital. It main advantage is that the information it provides is more easily understood by managers, especially non-financial managers. Its main disadvantages are

q     It is possible to calculate more than two different IRR’s for a project. This occurs where the cash flows over the life of the project are a combination of positive and negative values. Under these circumstances it is not easy to identify the real IRR and the method should be avoided.

q     In certain circumstances the IRR and the NPV can give conflicting results. This occurs because the IRR ignores the relative size of investments as it is based on a percentage return rather than the cash value of the return. As a result, when considering 2 projects, one may give an IRR of 10 per cent and the other an IRR of 13 per cent. However the project with the lower IRR may yield a higher NPV in cash terms and thus would be preferable.

Overall all four methods provide different approaches to investment appraisal and can provided a difference outlook on a proposed investment. Thus it would seem prudent that management should use all four methods in assessing investment projects. However the NPV approach is the one approach with the least amount of weaknesses or disadvantages and hence this approach should be used as the main guide in evaluating investment projects.

The four methods of investment appraisal use different approaches to evaluating the value of an investment for an organisation.  While three of the methods focus on cash flow, the accounting rate of return uses accounting profit in its appraisal calculation, providing a view of the overall profitability of the investment.

The accounting rate of return is based on the use of operating profit. The operating profit of a project is the difference between revenues earned by the project, less all the operating costs associated with the project, including depreciation. Note, the revenues and expenses must be directly related to the project and would exclude any element of fixed costs apportioned from elsewhere in the business.

All other appraisal methods use net cash flows as the basis for appraising capital projects. Ultimately cash flows are preferred to accounting profits due to the nature of capital investment projects. This is due to the fact that the timescale on capital projects between investing and receiving payback are quite long. Financial theory tells us that waiting for money has a cost. For example the cost of waiting for a customer to pay their account is the interest charge on a bank overdraft used while waiting. To take account of this cost of waiting, it is important to be mindful of the timing of the cash inflows and outflows of a business. The calculation of accounting profit is not concerned with the timing of cash flows and thus cannot take into account this cost of waiting.