Which Investment Appraisal Methods Are The Best Or Which to Choose

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We have reviewed the four methods of investment appraisal techniques:

• Payback
• Accounting rate of return
• Net Present Value
• Internal Rate of Return

The pros and cons of the payback, accounting rate of return and internal rate of return have been explained.

Fundamentally, the greatest disadvantage of the payback and accounting rate of return is that it ignores the time value or the present value of the inflows.

For accounting rate of return, besides ignoring the time value, it only refers to the accounting profit.As such, though they are simple to compute and understand, it’s not a true investment appraisal method as risk in the form of discount rate or cost of capital is completely not considered.

For Internal rate of return, the disadvantages have been outlined in my article.
Net Present Value method (NPV) has the following advantages:

• It is the most logical method to enhance shareholder value as it considers the economic profit concept (excess return after deducting its cost of finance).

• It’s also flexible, robust , simple to understand and able to cope with much complexity.

• It’s takes into account the time value of money and compares today’s investment with the future cash flows in today’s money.

• Furthermore, it’s take the risk of the investment into account through the choice of cost of capital or discount rate. The greater the risk so the cost of capital is getting higher.

• It considers the whole of the economic life of the investment, not just an arbitrary number of years

• It focuses on cash flow and not simply on accounting profit

When there is no budget constraints, Net present value (NPV) is particularly appropriate compared to other alternative investments method. The Internal rate of return cannot work well if it is comparing two mutually exclusive investment projects of different size or scope.

Even though, where we have budget constraints, we can also use the profitability index which is actually net present value reinstated ( present value of cash flows divide by investment outlay)

In view of the foregoing, the most appropriate or superior method should be the net present value or other method that uses discounted cash flow technique.

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