Capital Investment Appraisal
Evaluate the different methods of capital investment appraisal available to organisations and clearly show when each method would be used (if at all) illustrating your answer with relevant examples.
Capital investment appraisal can be described as the decision-making process used by organisations to evaluate different investments and to decide which fixed assets to purchase. In the following, four different methods of investment appraisal shall be discussed: accounting rate of return (ARR), payback period, net present value (NPV) and internal rate of return (IRR).
The ARR expresses the return on an investment as an annual percentage of the cost of that investment. To decide whether to accept or reject a project, organisations can set a minimum ARR which needs to be exceeded by the project’s ARR. The advantages of the ARR are that it is easy to understand and calculate and therefore accepted by many people.
The ARR is the only method that uses profits instead of cash flows. The profit figure, however, can be influenced by very subjective estimates such as depreciation and stock valuation and. Therefore, the ARR tends to be less reliable than cash-flow based methods. Another limitation of the ARR is that it ignores the time value of money.
Although the ARR has some shortcomings, it can still be used as an initial evaluation of a project as it is a very easy to use method. However it should not be used as the only method of investment appraisal as it might provide the wrong results.
The payback period calculates how long it will take to recover the initial cash outflow of the investment. Organisations can set a target payback period or compare the payback periods. By choosing the investment with the shortest payback period, the risk is minimised.
The limitations of this method are that is based on the unrealistic assumption that the cash flows evenly throughout the year. Moreover, it does not consider any cash flows occurring after the payback period.
Capital investment appraisal can be described as the decision-making process used by organisations to evaluate different investments and to decide which fixed assets to purchase. In the following, four different methods of investment appraisal shall be discussed: accounting rate of return (ARR), payback period, net present value (NPV) and internal rate of return (IRR).
The ARR expresses the return on an investment as an annual percentage of the cost of that investment. To decide whether to accept or reject a project, organisations can set a minimum ARR which needs to be exceeded by the project’s ARR. The advantages of the ARR are that it is easy to understand and calculate and therefore accepted by many people.
The ARR is the only method that uses profits instead of cash flows. The profit figure, however, can be influenced by very subjective estimates such as depreciation and stock valuation and. Therefore, the ARR tends to be less reliable than cash-flow based methods. Another limitation of the ARR is that it ignores the time value of money.
Although the ARR has some shortcomings, it can still be used as an initial evaluation of a project as it is a very easy to use method. However it should not be used as the only method of investment appraisal as it might provide the wrong results.
The payback period calculates how long it will take to recover the initial cash outflow of the investment. Organisations can set a target payback period or compare the payback periods. By choosing the investment with the shortest payback period, the risk is minimised.
The limitations of this method are that is based on the unrealistic assumption that the cash flows evenly throughout the year. Moreover, it does not consider any cash flows occurring after the payback period.