Investment appraisal

nature of investment decisions

large amounts of resources are often involved

It is often difficult and/or expensive to bail out of an investment once undertaken

Accounting rate of return(ARR) decision rule

For a project to be acceptable,it must achieve a target ARR as a minimum

Where two(or more)competing projects exceed the minimum rate,the one with the higher(or highest) ARR should be selected

Payback period

is the length of time it takes for an initial investment to be repaid out of the net cash inflows from a project

PP decision rule

for a project to be acceptable,

it should have a shorter payback period

than the maximum payback period set by the business

I two (or more)competing projects have paybak periods shorter than the maximum payback period,

the project with the shorter(shortest)payback period should be selected

Net present value

present value of cash inflows are compared to the PV of cash outflows,

the difference is the Net Present Value

recognises the Time Value of Money

NPV decision rule

If the NPV of a project is positive,

it should be accepted;

If it is negative it should be rejected

If two(or more)competing projects have positive NPVs,

the project with the higher(or highest) NPV should be selected

Why NPV is superior to ARR & PP

timing of the cash flows

The whole of the relevant cash flows

The objectives of the business

Internal rate of return(IRR)

definition

The internal rate of return is the discount rate,which,when applied to the future cash flows of a project,will produce an NPV of precisely zero

IRR decision rule

For a project to be acceptable,

It must meet a minimum IRR requirement(This should be the opportunity cost of finance.)

If two(or more)competing projects exceed the minimum IRR,

the one with the higher(or highest) IRR should be selected

Investment appraisal in practice

Businesses tend to use more than one method

NPV and IRR have become increasingly popular

Continued popularity of the PP and ARR methods

Larger businesses rely more heavily on NPV and IRR than smaller businesses do