Investment Appraisal Techniques: Payback Period, NPV, ARR, IRR

This presentation discusses the importance of investment appraisal and explores various techniques such as Payback Period, NPV, ARR, and IRR. It provides an analysis of three investment options for Victoria Babies Ltd and recommends the best option based on the appraisal techniques. The presentation also highlights the advantages and disadvantages of each technique.

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INTRODUCTION
Importance of investment appraisal
• Feasibility
• Decision-making

Cont.
Yield better results

Appraisal techniques
• Investment appraisal techniques play vital role in the company
to make better decisions related to investment.
• Victoria Babies Ltd is planning for expansion in varied
aspects.
• It is essential for taking decision with the help of appraisal
techniques.
• These include IRR (Internal Rate of Return), NPV (Net
Present Value), Payback period and ARR (Accounting Rate of
Return). These all techniques are discussed below-

Cont.
• Payback period
• It shows recovery period of invested project.

Cont.
• Advantages
• The main advantage of payback period is that it
evaluates risk associated with the project.
• Moreover, it provides clarity about when investment
will yield desired returns.
• Another advantage of this method is that it is simple
to calculate and provide better results by utilising
time factor.
• It is focused on risk factor of the project so that
adequate returns can be generated with much ease.

Cont.
• Disadvantages
• There are shortcomings as well of this method.
• It ignores cash flows which occurs after computation of
payback period. Furthermore, another drawback of such
method is that it ignores time value of money.
• This is required to assess project and generate good results.
Moreover, it leads to poor investment decisions. Another
disadvantage is that it does not consider profitability of the
project which leads to wrong results.
• It does not take into account subsequent investments which is
considered the biggest limitation of the method

Cont.
• NPV
• NPV is useful as it evaluates project on the basis of
profitability aspect.

Cont.
• Advantages
• The advantage of NPV is that it takes into account
time value of money.
• It aids in making effective decision as it rejects
project having less NPV.
• NPV aids in maximising organisation's value as
higher NPV of project maximises organisation's
worth.
• It takes into account all the cash flows over a life of
the project.

Cont.
• Disadvantages
• It is not suitable for the company as it is purely based
on discounting rate.
• This inculcates complexity which is the biggest
limitation of using NPV.
• NPV is merely based on forecasting and this leads to
incomplete information and as such, wrong decisions
are made.
• Another disadvantage of this method is that relying
on discounting rate may result into forego of better
investment projects.

Cont.
• ARR
• ARR is a capital investment technique which
provides clarity about return on investment
made by the company.

Cont.
• Advantages
• It is simple to calculate and interpret outcome drawn while assessing
project.
• Project's viability can be easily attained in quick manner and with less
time.
• It provides clarity about effectiveness of project in less time which saves
valuable time for management.
• Accounting profit is taken with reference to IRR.
• This eases evaluating profitability aspect of new project and aids in making
viable decisions.
• It is useful for investing in short-term projects which lapses within short
time frame

Cont.
• Disadvantages
• Major drawback of this method is that it does not consider
time value of money which is required while determining
usefulness of project.
• Cash flows from investment is required to evaluate properly
effectiveness of project but is ignored in this method.
• It is not suitable to implement ARR method as it does not
consider terminal value while investing in the project.
• It is not useful method for long-term projects and as such,
viable decision cannot be made in this aspect.

Cont.
• IRR
• IRR is another effective method which provides rate
of return on project over its useful life.

Cont.
• Advantages
• The main essence of this method is that it consider time value of money
while assessing project and as such, correct interpretation can be made.
• It is easier to compute and derive outcome in effective manner.
• Hurdle rate is ignored while calculating IRR of the project and as such,
wrong determination of investment decision is not possible.
• It does not take cost of capital in account and as such, it provides better
results.
• This method gives priority to increase or maximising in shareholder's
wealth.
• IRR is used for ranking project options as it provides rate of return on
various projects.

Cont.
• Disadvantages
• Reinvestment rate is estimated for life of project which leads to
inaccurate results regarding profitability of new project.
• Another disadvantage of IRR method is that computation is not easy
and incorporates complex calculations difficult for assessing usefulness
of project.
• IRR gives due importance only to profitability aspect but ignores
recovery of investment in near future.
• IRR is not helpful for when there are two mutually projects and as
such, interpretation cannot be done.
• It is unsuitable when size and term of two projects differ from each
other which is the biggest drawback of this method.

Application
Year Net cash inflow PV factor @ 10%
Discounted cash
inflow
Cumulative Cash
Flow
0 -500000
1 100000 0.909 90909.09 100000
2 100000 0.826 82644.63 200000
3 100000 0.751 75131.48 300000
4 100000 0.683 68301.35 400000
5 100000 0.621 62092.13 500000
379078.68
Initial investment 500000
NPV -120921.32

Cont.
Year Net cash inflow PV factor @ 10%
Discounted cash
inflow
Cumulative Cash
Flow
0 -500000
1 220000 0.909 200000 220000
2 240000 0.826 198347.11 460000
3 50000 0.751 37565.74 510000
4 70000 0.683 47810.94 580000
5 50000 0.621 31046.07 630000
514769.86
Initial investment 500000
NPV 14769.86

Cont.
Year Net cash inflow PV factor @ 10%
Discounted cash
inflow
Cumulative Cash
Flow
0 -500000
1 100000 0.909 90909.09 100000
2 100000 0.826 82644.63 200000
3 100000 0.751 75131.48 300000
4 100000 0.683 68301.35 400000
5 100000 0.621 62092.13 500000
379078.68
Initial investment 500000
NPV -120921.32

Cont.
• Investment option A
• Calculation of Payback period
• Formula- Initial Investment / Average Payback
• = 5 years
• Calculation of ARR
• Formula – Average Profit / Average Investment
• Average Investment is taken as initial investment
• = 70000 / 500000
• = 14 %
• Calculation of IRR
• Formula- PV (Present Value) of cash flows – Initial Investment
• = 0 %

Cont.
• Investment option B
• Calculation of Payback period
• = 2 + (40000 / 50000)
• = 2 + 0.8
• = 2.8 years
• Calculation of ARR
• = 50000 / 500000
• = 10 %
• Calculation of IRR
• = 11.58 %

Cont.
• Investment Option C
• Calculation of Payback period
• = 3 + 120000 / 150000
• = 3 + 0.8
• = 3.8 years
• Calculation of ARR
• = 25000 / 500000
• = 5 %
• Calculation of IRR
• = 10.17 %

Findings
• The investment appraisal techniques are calculated which shows
various options to be selected by Victoria Babies Ltd so that it may
expand its operations.
• There are three options which are available to company to choose the
best among them.
• Starting from option A which is expanding existing plant with
implementing bigger machines.
• It can be found out that this option is not good one to chose as it has
lower NPV which is considered for evaluating effective outcome of the
project.
• It can be interpreted that NPV is -120921 which implies that there is
negative aspect in case of this technique.
• It is not suitable for company as NPV should in be positive value.

Cont.
• Investment option B is related to building new
production plant in UK itself.
• By analysing investment appraisal techniques, it can
be said that company should invest in the same as
good profitability will be generated by it.
• This is evident from calculation of NPV which is
14729.86 and it implies that NPV is positive and will
provide good profits to Victoria Babies Ltd.
• It has more NPV and it should be adopted as per this
method.

Cont.
• Apart from this, IRR is 11.58 % which is
higher.
• This means that company should opt for this
investment option as better results are
provided in it.
• Next comes ARR which is 10 % implies that
accounting profit will be generated in effective
manner by investing in this project.

Cont.
• Investment option C is related to international expansion to
existing plant in China.
• It can be interpreted that investment in the project should not
be made.
• This is because NPV is less in this project which is just
2104.92.
• It implies that NPV is less than compared to other options.
• It is recommended that Higher NPV should be selected and in
this aspect, option B is suitable.

Cont.
• Besides this, payback period is 3.8 years which
means that it will take longer time to yield adequate
results.
• While, IRR ARR are 10.17 % and 5 % which is low
than other options.
• Thus, it can found out that Victoria Babies Ltd should
invest in the investment option B which is related to
expansion of plant in UK as all the investment
appraisal techniques are in favour of the same.
• It will be beneficial for the firm to achieve goals

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Online
Internal Rate of Return (IRR), 2018 [Online] Available Through:
<https://accountingexplained.com/managerial/capital-budgeting/irr>

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