Back to basics: Investment Appraisal Techniques
Before a business undertakes a project, it needs a way to assess whether the project is profitable. Module 3 of the TC Finance course introduces the four most common techniques used to appraise a capital investment, so we go back to basics.
This is the simplest of the four techniques and gives a length of time; the payback period is how long it takes for the project to generate sufficient cash inflows to break even and recoup the cash outlay needed to initiate the project.
The advantages of this technique are that it is very easy both to calculate and understand, even for those with no financial background. However, this simplicity is also a disadvantage as payback discriminates in favour of short-term projects and ignores anything that happens after the payback point has been reached. In addition, it ignores the time value of money.
Accounting Rate of Return (‘ARR’)
This technique is based on the following formula:
This formula shows the relationship between the investment needed to undertake a project and the accounting profits expected to be generated.
This relationship is a percentage which would be compared to a benchmark minimum level; the higher the ARR of a project the more attractive the investment is.
This is the only one of the four techniques which uses accounting profits rather than cashflows. In real life, there are several differences between these, but in the TC Finance course we only consider depreciation.
The main disadvantage of the ARR technique is that, as with payback, the time value of money is ignored.
Net Present Value (‘NPV’)
The strongest of the four techniques, the NPV of a project is calculated by taking all the cashflows which would arise as a result of undertaking the project, and discounting them to find their present value (link to NPV back to basics).
The discount rate used would usually be the company’s weighted average cost of capital (‘WACC’).
A positive NPV signifies that the project generates a return higher than the costs of paying the company’s financing, leaving an increase in shareholder wealth.
A negative NPV would mean that the project should not be undertaken as the cost of funding it exceeds its return.
Internal Rate of Return (‘IRR’)
Very similarly to the NPV technique, IRR involves discounting the project’s cashflows. However, under this technique the cashflows are discounted not once but twice, with the following formula then being used to interpolate/extrapolate the resulting NPVs to calculate the final answer.
A = lower discount rate chosen
B = higher discount rate chosen
NA = NPV at the lower discount rate
NB = NPV at the higher discount rate
The resulting IRR is a percentage which can be interpreted as the rate of return the project generates. This can then be compared to the company’s WACC to assess whether the project is viable; the IRR would need to exceed the WACC for the project to be accepted.
In theory, the NPV and IRR techniques compare the same two numbers and should always give the same investment conclusions but, under certain circumstances, IRR can generate several results, or misleading ones. For that reason, NPV is the stronger of the two techniques.
In real life, a business making a sizeable investment decision would be likely to use a combination of these techniques, but NPV is the strongest of the four techniques.
The TPS Advanced Finance course covers the NPV technique in more detail, looking at the effects of tax, inflation and cashflow equivalents on an investment decision.