Accounting - Introductory investment appraisal

Accounting rate of return (ARR) - the average accounting profit from the project expressed as a percentage of the average investment

Decision rule - projects with an ARR above a defined minimum are acceptable; the greater the ARR, the more attractive the project becomes

Conclusions on ARR:

- does not relate directly to shareholders' wealth - can lead to illogical conclusions;

- takes almost no account of the timing of cash flows

- ignores some relevant information and may take account of some irrelevant

- relatively simple to use

- much inferior to NPV

Payback Period (PP) - the length of time that it takes for the cash outflow for the initial investment to be repaid out of resulting cash inflows

Decision rule - projects with a PP up to a defined maximum period are acceptable, the shorter the PP, the more attractive the project

Conclusions on PP:

- does not relate the shareholders' wealth

- ignores inflows after the payback date

- takes little account of the timing of cash flows

- ignores much relevant information

- does not always provide clear signals and can be impractical to use

- much inferior to NPV, but it's easy to understand and can offer a liquidity insight, which might be the reason for its widespread use

Net present value (NPV) - the sum of the discounted values of the net cash flows from the investment       (Money has a time value)

Decision rule - all positive NPV investments enhance shareholders' wealth; the greater the NPV, the greater the enhancement and the greater the attractiveness of the project

PV of cash flow = cash flow x 1 / (1 + r)n, assuming a constant cost of capital. 

Discounting brings cash flows at different points in time to a common valuation basis (their present value), which enables them to be directly compared

Conclusions on NPV:

- relates directly to shareholders' wealth objective

- takes account of the timing of cash flows

- takes all relevant information into account

- provides clear signals and practical to use

Internal rate of return (IRR) - the discount rate that, when applied to cash flows of a project, causes it to have a zero NPV

IRR represents the average percentage return on the investment, taking account of the fact that cash may be flowing in and out of the project at various points in its life

Decision rule - projects that have an IRR greater than the cost of capital are acceptable; the greater the IRR, the more attractive the project

IRR cannot normally be calculated directly; a trial and error approach is usually necessary

Conclusions on IRR:

- does not relate directly to shareholders' wealth

- usually gives the same signals as NPV but can mislead where there are competing projects of different size

- takes account of the timing of cash flows

- takes all relevant information into account

- problems of multiple IRRs when there are unconventional cash flows

- inferior to NPV

All four methods identified are widely used

The discounting methods (NPV and IRR) show a steady increase in usage over time

Many businesses use more than one method

Larger businesses seem to be more sophisticated in their choice and use of appraisal methods than smaller ones