Investment appraisal methods test a project's cash recovery, accounting performance, value creation and percentage return. Net present value should normally lead value-maximising decisions, while other methods provide supporting information.
Why businesses use several appraisal methods
A project can recover its cash quickly yet create little long-term value, or show a strong accounting return while producing weak cash flows. Using several methods helps managers examine liquidity, profitability, risk and shareholder value from different angles.
Method comparison
| Method | Main measure | Basic decision rule | Main limitation |
|---|---|---|---|
| Payback | Time to recover initial investment | Accept within the required period | Ignores later cash flows and usually time value |
| ARR | Accounting profit as a percentage of investment | Accept above target ARR | Uses profit rather than project cash flow |
| NPV | Present value created | Accept if NPV is positive | Depends on forecasts and discount rate |
| IRR | Discount rate that makes NPV zero | Accept if IRR exceeds required return | Can mislead with unusual cash flows or exclusive projects |
| PI | Present value per unit invested | Accept if PI exceeds 1 | Ratio ranking can fail with scale and indivisibility |
Worked project data
Assume a project requires 100,000 and produces cash inflows of 40,000, 45,000 and 50,000 over three years. The required return is 10%.
Payback period
After two years, 85,000 has been recovered. The remaining 15,000 is 30% of the third-year inflow, so simple payback is approximately 2.3 years.
Net present value
The present values are approximately 36,364, 37,190 and 37,566. Total present value is 111,120, giving an NPV of about 11,120. The positive NPV supports acceptance.
Profitability index
PI = 111,120 ÷ 100,000 = 1.11. Every 1.00 invested produces about 1.11 of present value before subtracting the initial cost.
Internal rate of return
IRR is the discount rate that produces an NPV of zero. It can be estimated through a financial calculator, spreadsheet or interpolation. It should be compared with a required return that reflects project risk.
Accounting rate of return
ARR uses accounting profit and an investment base, so its answer depends on the stated formula and depreciation policy. Always show whether average or initial investment is used.
Which method should lead the decision?
NPV directly estimates the increase in value using cash flows and a required return. It is generally the strongest primary rule for independent projects. Payback can add a liquidity view, IRR communicates a percentage return, and PI can help under simple capital rationing.
Conflicting rankings
For mutually exclusive projects, NPV and IRR or PI may rank alternatives differently because of scale, timing or reinvestment assumptions. Compare incremental cash flows and prefer the alternative with the stronger incremental NPV when assumptions are sound.
Decision checklist
- Use incremental after-tax cash flows.
- Match the discount rate to project risk.
- Test sensitivity to key assumptions.
- Do not treat sunk costs as future cash flows.
- Consider capital constraints and project dependencies.
Frequently asked questions
Which appraisal method is best?
NPV is normally the strongest primary method for value-maximising decisions, supported by other measures and risk analysis.
Why is payback still used?
It is simple and highlights liquidity and exposure, but it should not replace a complete discounted-cash-flow analysis.
Can IRR and NPV disagree?
Yes. Project scale, timing and non-conventional cash flows can produce conflicts.
What does a PI of 1.11 mean?
The present value of future inflows is 1.11 for each 1.00 of initial investment.
Continue learning
- The wider project-evaluation process
- Internal rate of return
- Profitability index
- Limitations of profitability index
- Capital-rationing decisions
Use the formulas and examples as learning tools. Real decisions should use reliable data, appropriate assumptions and professional judgment where necessary.
As regards the use of evaluation methods, most companies use payback criterion. In addition to payback and or other methods, companies also use internal rate of return (IRR) and net present value (NPV) methods. A few companies use accounting rate of return (ARR) method. Internal rate of return (IRR) is the second most popular technique.
The major reason for payback to be more popular than the discounted cash flow method techniques is the executives’ lack of familiarity with discounted cash flow techniques. Other factors are lack of technical people and sometimes unwillingness of top management to use the discounted cash flow techniques. One large manufacturing and marketing organization, for example, thinks that conditions of its business are such that the discounted cash flow techniques are not needed. By business conditions the company perhaps means its marketing nature, and its products being in seller’s markets. Another company feels that replacement projects are very frequent in the company, and therefore, it is not necessary to use the discounted cash flow techniques for such projects. Both these companies have fallacious approaches towards investment analysis. They should subject all capital expenditures to formal evaluation.
The practice of companies in Asian countries regards the use of evaluation criteria is similar to that in USA. Almost four-fifths of US firms use either the internal rate of return or net present value models, but only about one-fifth use such discounting techniques without using the payback period or average rate of return methods. The tendency of US firms to use native techniques as supplementary tools has also been reported in recent studies. However, firms in USA have come to depend increasingly on the discounted cash flow techniques, particularly internal rate of return. The British companies use both discounted cash flow techniques and return on capital, sometimes in combination sometimes solely, in their investment evaluation; the use of payback is widespread. In recent years the use of discounted cash flow methods has increased in UK, and net present value (NPV) is more popular than internal rate of return (IRR). However, this increase has not reduced the importance of traditional methods such as payback and return on investment. Payback continuous to be employed by almost all companies
One significant difference between practice in Asian countries and USA is that payback is used in Asian countries as a “primary” method and IRR/NPV as a “secondary” method, while it is just reverse in USA. Asian countries managers feel that payback is a convenient method of communicating on investment’s desirability, and it best protects the recovery of capital-a secure commodity in the developing countries.
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