Investment appraisal is an attempt to identify the attractiveness of an investment. Put simply, its objective is to assess the viability of a certain project or program, and the value it generates.
In addition, this attempt is highly influential to the decision-making process in investment as it investigates whether it is worth the spending. Of course, it is meaningless to invest in something that is not profitable.
Accordingly, there are several techniques to conduct investment appraisal. Each technique poses dissimilar viewpoints to the assessment. The techniques are as follows.
Payback period assesses the required time for an investment to generate sufficient cash-flow to cover the initial cost of the project. Basically, the shorter the time, the better.
For example, an investment requires USD 100.000 and there are two ways that generate the necessary cash-flow in 2 years and 2.5 years respectively. Automatically, the first investment is better.
Accounting Rate of Return
The accounting rate of return (ARR) simply compares the amount you are expected to acquire from an investment to the one you need to invest in. Commonly, the comparison is between the average annual profit and the average amount of capital.
The formula for ARR is as follows.
ARR=(Average annual profit after tax / Initial investment) X 100
Discounted cash flow uses a discount rate to calculate the present-day equivalent of future cashflow. Accordingly, there are two of them which are net present value (NPV) and internal rate of return (IRR) respectively.
NPV is the sum of discounted future cash inflow and outflow pertaining to the project. Arguably, this is the most common technique of investment appraisal.
Meanwhile, IRR is the discounting rate in which the company will neither make a loss nor make a profit. Additionally, the discounting rate brings discounted future cash flow and the initial investment at an equal amount. Moreover, this technique is accessible through trial and error.