Appraisal Options

Investment decisions for businesses require thorough evaluation of the investment proposals. One or more of the methods that are used in the screening process of these investment proposals are Accounting Rate of Return (ARR), Payback Period (PP), Net Present Value (NPV) and Internal Rate of Return (IRR).

Accounting Rate of Return (ARR)

The method involves the taking the average annual operating profit generated by the investment as a percentage of the average investment to earn that profit.

The result of the above calculation is a minimum target to be achieved for a project to be considered acceptable however failure to meet the businesses’ minimum rate will call for a rejection of the project.

Also, should a business have various options of investments and they all have met and surpassed the minimum rate, then the investment with the highest Accounting Rate of Return should be chosen.

This method, which is expressed as a percentage, is simple and easy to calculate and is used as a measure of business performance and management performance. However, since investors focus on cash flows and this method focuses on accounting profit, this method may not or will rarely be used to evaluate the project.

Another issue with ARR is that unlike the Net Present Value and the Internal Rate of Return (both detailed below) the ARR does not take the time value of money into consideration.

The concept and accounting of the ARR is similar to the Payback Period method and therefore its flaws are alike.

Payback Period (PP)

This method calculates the time taken to regain the initial investment into the project and the shorter the time period of payback is more favoured to a longer payback period. This rate is also compared to and should be below the company’s maximum period of payback to consider if acceptable.

This method is conservative and since it too is easy and simple to calculate, like the ARR, is therefore preferred by managers. This method as its name suggests...