CAPITAL BUDGETING:

INVESMENT
APPRAISAL

ARR, PAYBACK, NPV,

IRR
 NATURE OF INVESTMENT
DECISIONS
Out lay precedes economic benefits hence concept
of Time Value of money

Large size of outlay/resources

Difficult to bail out of investment

HOW TO EVALUATE INVESTMENT

OPPERTUNITIES?
 ACCOUNTING RATE OF RETURN
(ARR)
It is defined as % of the average investment
translated as accounting profit over the
life of project

ARR = Average Annual Profit

_______________________________ x 100%
Average investment to earn that profit

Average Investment = Cost of machine + Disposal Value

2
MERITS DEMERITS
1. Widely in Practice 1. Accounting profit is
of less value as
2. It is a measure of
compared to
profit hence liked by
accounting profits
many as evaluation
criteria of 2. Can not be useful for
investment evaluating options
3. It ignores time value
3. % results are easy to
of money
comprehend by
managers 4. It is useful for short
term reporting
instead of whole
project
 PAYBACK PERIOD (PP)
It is length of time during which initial
investment/out flow is recovered from
cash inflows of the project.
MERITS DEMERITS
1. It is preferred to 1. Cash flows beyond
have minimum pp Payback period are
2. It is used in ignored
comparing options 2. It ignores element of
risk and only focus
on quick recovery
NET PRESENT VALUE (NPV)
It is the present value of future cash flows of the
project worked out after considering all costs
and benefits of investment.

It is assumed that present value of future cash

flows should be >investment being made.

Following ingredients of Time Factor are

incorporated
Interest Loss, Risk and Inflation
 Logical investor desires that proposed
investment should yield a return that is
greater than Risk free rate of return after
giving allowances for risk and inflation

Discount Inflation
Interest foregone Rate

Risk Premium
PV of cash flows of year n
= Actual cash flow of year n
( 1+ r )n

As the time in which cash flow is to be

received increases its present value of it
would diminish proportionately.

Using discount tables

MERITS
DEMERITS
1. Time value of the
money 1. Managers are not
2. All cash flows are familiar with this
recorded hence do not like it
3. Maximization of
shareholders wealth is
2. It is not a measure of
ascertained profitability
4. Additivity is possible
5. Useful both for
evaluating mutually
exclusive projects or
otherwise.
6. It takes in to account
investment size
INTERNAL RATE OF RETURN (IRR)

It is the discount rate that when applied to

future cash flows of the project, will
produce an NPV of Zero.
Simply when present value of future cash
flows is equal to the cash outflow
Trial and the error is the approach that must
usually be adapted
 Formula

=A+ ( NPVA ) x B –A
NPVB
Where A and B are the two discount rates.
 DEMERITS
MERITS
1. It does not address scale
1. Provides the of investment hence
minimum may lead to a wrong
decision
requirement
2. It is represented in %
2. Can choose from hence easily
options. One with understandable
highest IRR 3. Additivity is not
possible.
4. It is useful when
projects are not mutually
exclusive. Projects with
yield than opportunity
cost are accepted.