Investment appraisal

Payback

The amount of time taken to recover the initial cost of an investment project.

Strength of Payback method

Quick project selection for financially unstable businesses; easily understood by non-financial personnel; good for comparing competing projects; suitable for dynamic markets.

Weakness of Payback method

Ignores cash flow after payback; does not account for the time value of money; encourages short-term thinking.

Average (Accounting) Rate of Return (ARR)

Total average returns of a project annually, expressed as a percentage of the initial investment. Formula: (Total NCF / Years of project) / Initial investment.

Strength of ARR method

Allows comparison of project viability against opportunity cost/interest rates; easy to compare different projects; relatively easy for non-financial decision-makers to understand percentages.

Weakness of ARR method

Does not account for the time value of money, leading to distorted figures for longer projects; requires accurate data and skilled personnel.

Net Present Value (NPV)

Calculates the current monetary value of a project’s future cash flows by applying discounted cash flows, thereby accounting for the time value of money.

Strength of NPV method

Accounts for the time value of money; DCF can be adjusted for economic changes; provides a clear decision (positive NPV = invest, negative NPV = do not invest).

Weakness of NPV method

Based on estimates requiring accurate data and skilled personnel; high uncertainty for new/unusual products; DCF rate can be subjective and inaccurate; can be hard to calculate.