Investment Appraisal also known as Capital Budgeting is used to asses whether capital expenditure on a particular project will be beneficial for the entity or not. These techniques can be used to evaluate projects both in the private and public sector companies. Most commonly used techniques include Accounting Rate of Return (ARR), Payback Period, Discounted Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR), Modified Internal Rate of Return (MIRR) and Adjusted Present Value (APV). ARR and Payback period are non discounted methods while all other mentioned methods are discounted. By discounted it is meant that the time value of money is considered in these methods.
Accounting Rate of Return (ARR)
This technique compares the profit earned by the project to the initial investment required for the project. Thus a project with higher rate of return is preferred.
Payback period calculates the time taken by a project to recoup the initial investment. A company evaluating projects by this technique would prefer projects with short payback period than those with longer payback periods. It is simple to calculate and easy to understand.
Discounted Payback Period
This technique works similar to payback period, the difference here is that discounted values of cash flows are used for calculation of the payback period.
Net Present Value (NPV)
The NPV method calculates the present values for all future cash flows. The discount rate may be the Weighted Average Cost of Capital (WACC) or it may be any cost of capital depending on the risk of the project in consideration. This type of appraisal is regarded superior to the ARR and the payback period, however there are certain assumptions, on which this technique is based, making its evaluation less reliable.
Internal Rate of Return (IRR)
IRR calculates the rate at which the NPV of a project equals zero. According to this method if the cost of capital of a company is more than the IRR, the project will be rejected and if it is lower than the cost of capital it is likely to be accepted. IRR and NPV concepts are correlated.
Modified Internal Rate of Return (MIRR)
IRR assumes that reinvestment rate of the company is the IRR. MIRR overcomes this assumption and evaluate projects on the assumption that the reinvestment rate is the same as the company’s cost of capital. This assumption for the cost of capital makes it a more effective technique as compared to the IRR.
Adjusted Present Value (APV)
APV method is used for evaluating investment in projects where risks for a project are different from the company considering such undertakings. This type of evaluation overcomes weaknesses present in the NPV technique.