Investment Appraisal Techniques: Payback Period, ARR, NPV, And IRR

(a)Payback period

Goodflow Plc is the house building entity that is planning to build 200 houses on development site during the next 4 years. 2 types of houses will be build that is small houses and large houses. Cost for the houses will involve the variable construction cost and fixed variable cost that will be expensed for construction of utilities, garden drainage and new roads. The main purpose of the report is to evaluate the viability of the project through various techniques of investment appraisal. Various techniques those will be used are payback period, accounting rate of return, net present value and internal rate of return. The report will further focus on merits and demerits of each technique those will be used for measuring the project’s viability. Finally, based on the analysis comments will be provided regarding the viability of the project (Yuniningsih, Widodo and Wajdi 2017).

Payback period is used for determining the time period that will be required for recovering the project’s initial cash outflow. In other words, it is the method used for computing the required time for earning back the amount incurred in investment through consecutive cash inflows. It is calculated as follows –

Payback period = Initial investment / cash flow per period

Generally, the project is accepted only if the payback period is lower as compared to the targeted payback period of the entity. Managers often have issues while they are required to select on project among 2 or more than that. Taking such decision is crucial as the resources are always limited. Hence, they are required to select the project that will maximize the return. Various merits and demerits are associated with the payback period as discussed below for critically analysing the technique (Arrow 2017).

Merits of payback period are as follows –

• Easy to understand and simple to use – this is the most noteworthy advantage of this technique. This approach requires comparatively few inputs and is easier to compute as compared to other methods of capital budgeting. Only requirement is the initial cost of the project and the annual cash flows. Though other methods are also simple they require comparatively large numbers of assumptions (Moodley, Muller and Ward 2016).
• Preference for the liquidity – it is crucial information that is not revealed by any other methods. Generally the project with the shorter payback period is also exposed to lower level of risk. This information is significantly crucial for small businesses with the limited resources as small businesses require quick recovery of the cost so that the amount can be reinvested in other opportunities.
• Quick solution – as payback period is simple to compute and it requires fewer assumptions, business managers are able to quickly compute the project’s payback period. it assists them in making quick decisions which is important for the entities with the limited resources.
• Useful where uncertainty involved – it is useful for the industries with uncertainty or that experiences rapid changes in technologies. Such kind of uncertainties makes it tough for estimating the future cash inflows. Hence, undertaking the projects with the shorter payback period assists to reduce the likelihood of loss through the obsolescence (Gotze, Northcott and Schuster 2016).

Demerits and limitations of payback period are as follows –

• Time value of money is ignored – this is the major disadvantage of payback period that it does not consider the time value of money that is an important aspect of investment. Time value of money states that the worth of money today is more as compared to the worth of money to be received later as the money today has potential of re-investment. Payback period approach does not consider this factor and thereby distorts the cash flow’s actual value.
• Does not cover all the cash flows – this method takes into account cash flows only for the period required for recovering the initial amount required for investment. However, it does not consider the cash flows for the subsequent period. Such limited view may force the analysts to overlook the project that may generate higher amount of cash flows in subsequent periods.
• Ignores profitability – any project with shorter payback period does not provide guarantee that it will be most profitable. Likelihood is there that the project will stop providing cash inflows at the payback period or the cash inflows will be significantly reduced after the payback period. In both the scenarios, project will become unviable (Baum and Crosby 2014)

From the given scenario, it has been computed that the life of the project is 4 years whereas the payback period is 2.06 years. Hence, if only payback period is considered for evaluating the project, the project shall be accepted as the initial investment amount is recovered during the lifetime of the project and hence, viable.

This method is used as the investment appraisal technique for estimating whether the investment is to be undertaken or not. it is also known as the average or simple return rate. It measures the return or profit amount expected from any project. It is a capital budgeting approach used for quickly computing the profitability of the entity. Generally, this method is used as the general comparison tool among various projects as it is basic tool for looking into the performance of an investment (Yuniningsih, Widodo and Wajdi 2017). Various merits and demerits are associated with the accounting rate of return as discussed below for critically analysing the technique.

(b)Accounting rate of return

Merits of ARR are as follows –

• Easy to calculate – this method is very easy to understand and simple to understand same as payback period approach. It takes into account total savings or profits over the useful life of the project.
• Measures profitability – it takes into account the net earning concept that is earnings after providing for depreciation and tax. This is an important factor while appraising the investment proposal
• Comparison – This method helps in comparing new project with the nature of cost reduction or the projects of competitive nature. Further, it portrays clear picture for the project’s profitability (Baucells and Borgonovo 2013).
• Accounting profit – this method can be used for computing the accounting profit from accounting records and rate of the return. It helps in measuring the firm’s current performance. Further, it helps in satisfying the owner’s interest as the owners are interested in knowing the return on investment.

Demerits and limitations of ARR are as follows –

• Results will be different if one analyst calculates ROI and and other analyst computes ARR. Hence, it will be problematic while taking decisions.
• This technique does not take into account the time factor. Major demerit of ARR for selecting alternative use of the funds is the time value is not considered (Brooks 2015).
• It does not consider life period of different investments. However, average earnings are computed through considering the useful life of the investment. Owing to this initial investment or average investment may remain same irrespective of the life period of the project.

From the given scenario, it has been computed that the ARR of the project is 52.52% that is a positive return. Hence, if only ARR is considered for evaluating the project, the project shall be accepted as the ARR of the project is positive and hence, viable.

It is present value of any investment’s projected cash inflows reduced by the amount of initial amount expensed for acquiring the investment. It is used for evaluating the investment decisions and it provides clear aspect regarding whether the investment will add value to the company or not. Generally, if the investment has positive NPV it is considered as acceptable. NPV technique can be used for future capital projects as well as acquisitions (Pasqual, Padilla and Jadotte 2013). Various merits and demerits are associated with the NPV as discussed below for critically analysing the technique.

Merits of NPV are as follows –

• Assumptions for re-investment – unlike the IRR technique, NPV technique makes sense as it does not make any assumptions regarding the fact that the cash flows will be re-invested at the IRR that is nearly impossible.
• Accepts conventional pattern of cash flow – at the year 0 there is initial outflow for investment and positive or negative cash generally generated from year 1. Under NPV approach dealing with the conventional cash flows is simple (Butler et al. 2014).
• Consideration for all the cash flows – this approach takes into account all the cash flows over the project’s life. Hence, it is comparatively better as compared to the payback period that only takes into account the period required for recovering the amount of initial outflow.
• Measures profitability – if one project is to be chosen from 2 or more projects NVP approach is a god measure as it measures the profitability of each project. Unlike the IRR method that may ends up in selecting the small projects with higher IRR for the mutually exclusive projects NPV is good measure to consider the project with long term creation of value (McAuliffe 2015).

Demerits and limitations of NPV are as follows –

• Projection of the opportunity cost – measuring the opportunity cost is difficult with NPV. Opportunity cost is specifically considered while measuring the initial outflow. Hence, ignoring opportunity cost may distort the outcome
• Ignoring the sunk cost – under capital budgeting sunk costs that is the costs expensed before starting the project are not considered. However, the amount of sunk costs may be large and hence ignoring those may create difficulties for the finance team.
• Determinations of required rate of return – determining the rate at which the cash flows shall be discounted are difficult for the finance team. Wrong estimation of discounting rate may results into lower or higher NPVs which in turn may distort the decisions (Leyman and Vanhoucke 2016).

From the given scenario, it has been computed that the NPV of the project is £ 10,461,583.95 that is a positive NPV. Hence, if only NPV is considered for evaluating the project, the project shall be accepted as the NPV of the project is positive and hence, viable.

It is the rate of interest at which net present value of the investment of all cash flows is zero or in other words it is the rate at which the cash inflow is equal to cash outflows. Generally, higher rate of return for the project acceptability of the project is more. Further, IRR can be used to rank various projects acceptability if the project is to be chosen from 2 or multiple projects. Various merits and demerits are associated with the internal rate of return as discussed below for critically analysing the technique (Levy 2015).

Merits of IRR –

• Time value of money – most important advantage of IRR is that it takes into account the time value of money while analysing a project
• Simplicity – most attractive feature of IRR approach is it is simple and easy to interpret the outcome after the calculation of IRR.
• Required rate of return is rough estimate – after computing the IRR it can be compared with the hurdle rate. If IRR is far away from projected rate of return the project can be rejected easily (Leung et al. 2014).

 Demerits and limitations of IRR –

• Ignoring economies of scale – major advantage of IRR is that the actual dollar values of the benefits are ignored. Hence, the selection of project may end up with wrong selection
• Mutually exclusive project – if the investor is come across the mutually exclusive project that is if one is accepted another cannot be accepted knowing the worth of investment is important. However, IRR provides the interpretation in percentage terms that is not sufficient as economies of scale is also important in selecting the project (Gallo 2014).

From the given scenario, it has been computed that the IRR of the project is 36.20% that is more than required rate of return that is 12%. Hence, if only IRR is considered for evaluating the project, the project shall be accepted as the IRR of the project is more than required rate of return and hence, viable.

From the above it can be concluded that the using all the approaches like payback period, accounting rate of return, net present value and internal rate of return it is identified that in all the aspects the project is viable. Hence, it can be commented that the project is viable and shall be accepted.

Reference 

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Baucells, M. and Borgonovo, E., 2013. Invariant probabilistic sensitivity analysis. Management Science, 59(11), pp.2536-2549.

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