There are several methods used in investment appraisal, with each having its own advantages and limitations:
Payback Period This method calculates the time required to recoup the initial investment from the cash inflows generated by the project. Although simple, it does not consider the time value of money or cash flows beyond the payback period.
Net Present Value (NPV) NPV is the difference between the present value of cash inflows and outflows over the project's life. This method considers the time value of money and provides a direct measure of the expected increase in company value. A positive NPV indicates a profitable investment.
Internal Rate of Return (IRR) IRR is the discount rate at which the NPV of an investment is zero. It represents the project's expected rate of return. Projects with an IRR higher than the company's required rate of return are typically considered acceptable.
Profitability Index (PI) PI is the ratio of the present value of future cash flows to the initial investment. A PI greater than 1 indicates a good investment. It is useful when comparing projects of different scales.
Accounting Rate of Return (ARR) ARR calculates the return on investment based on accounting profits rather than cash flows. While easy to calculate, it does not consider the time value of money and may not reflect the true profitability of a project.