Investment decisions are some of the most important decisions a firm has to make because of the large outlays and length of time involved. Various techniques have been developed to help appraise project options available to a firm. Appropriate decision rules are applied after evaluation in the light of their virtues as well as their limitations.
The payback period method provides important information on how long funds will be tied up in a project and emphasizes early recovery of investment. It also serves as an indicator of a project's risk since cash flows expected in the distant future are riskier. It is simple to calculate and understand, and hence less costly. This method fails to consider cash flows occurring after the payback period and the time value of money, and hence has no relationship with shareholder wealth maximization.
The net present value (NPV) method considers all cash flows related to the project and discounts them to factor in the time value of money. As a result, it is always consistent with the objective of shareholder wealth maximization. However, it is a hard task to determine the discount rate and the opportunity cost of investing in projects rather than capital markets, and to estimate cash flows.
The profitability index method shows the relative profitability of a project by showing the benefit/cost ratio of the project. Like NPV, it uses all cash flows and discounts them to get present values. It similarly suffers the difficulty of determining the discount rate as well as estimating the future cash flow amount.
Internal rate of return (IRR) shows the break-even point, making it easy to decide whether there is a surplus return to shareholders. It considers the time value of money accruing in the entire life of the project. However, it is unreliable when there are non-normal cash flows, as these result in multiple rates or in evaluating mutually exclusive projects, especially those that differ in scale. The method is also tedious and time-consuming to calculate for projects with a long life.
Readily calculated from accounting data, the accounting rate of return (ARR) incorporates the entire stream of income in calculating profitability. However, accounting profits are based on assumptions and include non-cash items. Averaging of income ignores the time value of money, giving more weight to the distant receipts. A firm using ARR uses an arbitrary cut-off yardstick, usually return on current assets. Hence, companies earning high returns may reject profitable projects, or the less profitable ones may accept bad projects.