Investment Appraisal Techniques

Investment appraisal techniques are methodologies through which profitability prospects of any
future investments is evaluated and compared with other available options. Variety of techniques
are in available in practice and theory. These techniques are classified under two main heads i.e.
traditional methods such like payback period and cash flow methods such like Net Present Value
(NPV) and Internal Rate of Return (IRR) (Akinbuli, 2011). There has been a long debate on
which investment appraisal technique is more effective and which is widely being practiced
among the professionals. Most of the evidence favor usage of discounted cash flow techniques
(Klammer, 1970; Bailes Nielsen and Lawton, 1988; Farragher, Kleiman, and Sahu, 1999) while
some studies indicate usage of the traditional methods as well (Falusi, 1983; Cotton and
Schinski, 1999; Pandey, 2002) and there has been evidence that usage of discounted cash flow
techniques is increasing among professionals (Gitman and Forrester, 1977; Akinbuli, 2011;
Farragher, Kleiman, and Sahu, 1999). While IRR was found to be the technique of primary
evaluation in many studies of developed countries while in developing countries like Nigeria still
use payback period widely (Kantudu, 2007). Following discussion would highlight the merits
and demerits of these widely used appraisal techniques:

Payback Period
Payback period is the length of time till that all invested money could be recovered from the
project (Dury, 2002). The rule of thumb is to select the project having least of payback period
(Akinbuli, 2011). This is a pretty simple and straight forward investment appraisal technique
(Kantudu, 2007). The real problem with this problem is that it do not considers the time value of
money. This problem is adjusted in latter version of this techniques i.e. discounted payback
period in which the discounted value of the cash flows is considered to calculate payback period.
Still this technique do not focus on the profitability of the project it just entails how much time it
would take to recover investment money from the project (Gitman, 2007). This technique also
ignores timing of each cash flow within certain payback period. There are other problems with
this method such like this techniques is not use in comparing projects having equal payback
periods and use of this technique only may lead the organization to excessively invest in the
projects with short term horizons (Van-Horne, 2002). This technique however could be used as

initial screening technique and in situations when recovery of the investment money is important
at an early or specified date. Relying on this method could ensure the good liquidity position and
lesser risk prospects as short term projects are less risky (ICA).

Net Present Value (NPV)

Net present value is the difference between the initial outlay (investment) of the project and
discounted cash flows of the project (Akinbuli, 2011). It provides the absolute value of profit and
loss from a specific project after considering the time value of money. This is a handy technique
which is also used widely in investment related decisions. The main merits of this technique is
that it directly measures the incremental value in the shareholders wealth which is major focus
of every corporation. It also considers all the relevant cash flows ignoring ambiguous accounting
rules and procedure and provides a clear criteria as to which project is to be accepted and
rejected (Accept projects with positive NPV and reject with negative NPV) (ICA). The problem
with this method is that it do not considers the magnitude of the investment and rate of return on
that investment, thus it is difficult to compare relative profitability of the projects in terms of rate
of return on investment (Gitman, 2007).

Internal Rate of Return (IRR)

IRR is that rate which makes NPV of a project zero that is if its cash inflows are discounted with
that rate these would just equalize the initial outlay of the project (Gitman, 2007). This rate
represents the true interest rate that is earned by investing in the project (Akinbuli, 2011). The
main merit of the IRR is that the figure provided by this method is clearly understandable and
comparable to other projects and the rate of discount in IRR is not specified or determined before
the causation of IRR. The problems associated with this method is that this method do not
considers the relative size of investment in different projects and the decision regarding mutually
exclusive projects could be difficult using this method. Moreover, non-conventional cash flows
could not be dealt with this method (ICA). Another variation to the IRR is incremental IRR
which measures the incremental return from choosing an expensive project over and less
expensive project. It also yields a rate which depicts the premium for accepting risk of higher
investment project. This method is useful when comparing the two projects with different
investment amounts.

Conclusion
On the whole, different methods of investment appraisal are being used in different parts of the
world depending upon suitability of the method and practice. It is suggested that no single
method of investment appraisal is perfect regarding analysis and all methods have certain
limitations. So combination of the available methods could be used to make rational decision
depending upon the situations. It is however, useful to understand the applications and
limitations of different methods so that suitable methods could be chosen for investment
decisions.

References
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