Investment appraisal methods are techniques used to evaluate investment proposals and assist companies in determining their desirability based on their income-generating potential. These methods also help rank proposals in order of preference. A sound appraisal method should enable the company to measure the real worth of a proposal and make informed accept-or-reject decisions.
Investment appraisal is one of the eight core topics within Financial Management and is frequently tested in professional examinations. Commonly used methods include:
- Payback Period
- Accounting Rate of Return (ARR)
- Discounted Cash Flow (DCF) methods such as Net Present Value (NPV) and Internal Rate of Return (IRR)
Characteristics of a Sound Appraisal Method
- Rank proposals in order of their desirability.
- Distinguish between acceptable and unacceptable projects.
- Provide a criterion for choosing among alternative projects.
- Recognize the importance of the time value of money (preferring larger and earlier benefits).
- Establish clear selection criteria.
- Consider the pattern and timing of cash flows.
1. Payback Period Method
The payback period is the time required to recover the initial investment from the project’s net cash inflows (after tax).
Example: An investment of ₹10 lakhs generates the following net cash flows (₹ in thousands):
| Year | Annual Cash Flow | Cumulative Cash Flow |
| 0 | -1000 | -1000 |
| 1 | 370 | -630 |
| 2 | 250 | -380 |
| 3 | 280 | -100 |
| 4 | 340 | 240 |
| 5 | 360 | 600 |
Using the formula: P = E + (B / C)
Where:
P = Payback period
E = Years before final recovery
B = Balance to be recovered
C = Cash flow in year of recovery
The payback period is 3.29 years (about 3 years and 4 months).
- Advantages:
- Simple to calculate and understand.
- Limitations:
- Ignores cash flows after the payback period.
- Does not account for the time value of money.
2. Net Present Value (NPV) Method
NPV measures the difference between the present value of cash inflows and the present value of cash outflows, using an appropriate discount rate.
- Decision Rule:
- Accept the project if NPV > 0 (positive).
- Reject the project if NPV < 0 (negative).
- When comparing mutually exclusive projects, choose the one with the higher NPV.
3. Internal Rate of Return (IRR) Method
IRR is the discount rate at which the NPV of a project becomes zero. Unlike the NPV method, the discount rate is unknown and is determined through trial-and-error or interpolation. The project is acceptable if IRR ≥ cost of capital.
4. Discounted Cash Flow (DCF) Analysis
DCF evaluates a project by discounting all future cash inflows and outflows to their present value using the time value of money principle. It is useful for assessing the long-term profitability and viability of an investment.
5. Hurdle Rate Method
The hurdle rate (or required rate of return) is the minimum acceptable return a company expects from an investment. A project is approved only if its IRR meets or exceeds this rate.
6. Accounting Rate of Return (ARR)
ARR measures the percentage return on an investment based on accounting profits, rather than cash flows, and does not consider the time value of money.
- Formula:
- ARR = (Average Annual Accounting Profit / Initial Investment) × 100
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