This article looks at the four most popular of these (see figure 1). Note that one uses profits but all the others use cash flow.
For each of these methods it is necessary to estimate future profits or cash flows arising from the new investments. Often, the objective is to choose between alternatives fixed assets. As the same assumptions are made for each alternative, the results become more valid.
Table 1 Summary of capital investment appraisal methods.
Method Base .
Accounting rate of return (ARR) Accounting rate of return (ARR) .
Payback period (PBP) Cash flows.
Net present value (NPV) Discounted cash flows.
Internal rate of return (IRR) Discounted cash flows.
3.1 The Payback Period Method (PBP).
The pay back period is the number of years it will take to recover the original investment from the net cash flows resulting from a capital investment project. If the payback period is equal to or less than a predetermined target value, the investment project is acceptable. It is possible to obtain an estimate of the payback period to several decimal places if cash flows are assumed to occur evenly throughout each year, but a high degree of accuracy on estimating the payback period is not necessarily desirable. Since it does not offer information which is especially useful. A figure to the nearest year or half-year is sufficient. While research has shown that payback is the most popular investment appraisal technique, it suffers from such serious shortcomings that it can only really be regarded as a first screening method .
3.2 The Accounting Rate of Return Method (ARR).
The accounting rate of return attempts to express the return on the investment as an annual percentage of the cost of that investment. This is similar to comparing interest-bearing bank and building society accounts with each other when deciding where to invest your money. Businesses using this method usually set a minimum threshold rate which must be equalled or exceeded by the ARR.