1. Payback period analysis
The payback period measures the amount of time it will take to recoup, in the form of net cash inflows, the net initial investment in a project. This is a common measure of the risk associated with the investment.
Investments with a shorter payback period are generally considered less risky. However, other factors such as time value of money, and net cash flows after the initial investment is recovered, are not considered in this method.
2. Accounting rate of return
The accounting rate of return (ARR) calculates the return of a project by taking the annual net income and dividing it by the initial investment in the project.
Let’s say you want to buy a piece of equipment for $1 million. If the annual net income generated by the equipment was $80,000, then the project has an ARR of 8%. When comparing projects, investments with a higher ARR will be more attractive.
Although the simplicity of ARR makes it a commonly used ratio for project appraisal, this simplicity also leaves out a number of important aspects. ARR does not take account of the time value of money, which dictates that a dollar today is worth more than a dollar in five years(that’s because you can invest today’s money to earn a return). ARR also doesn’t consider cash flows, which is a crucial aspect of any investment project.
3. Net present value
The net present value (NPV) method calculates the expected net monetary gain or loss from a project by bringing all expected future cash inflows and outflows to the present time.
Although the exact value of the project can only be known after its completion, the NPV allows entrepreneurs to account for the time value of money when appraising long-term projects.
4. Internal rate of return
Simply put, the internal rate of return (IRR) gives you the average annual rate of return of a project throughout its lifetime. Like the NPV, the IRR is a discounted cash flow analysis, meaning that it accounts for the diminishing value of money over time. Under this method, the higher a project’s projected IRR, the more desirable it will be.
While the IRR provides the investment’s rate of return, the NPV provides the dollar amount, at present time, that the investment would generate.
IRR is often used jointly with NPV. That’s because a project could have a low IRR, but a high NPV, depending on the initial investment outflows and net future inflows. This would indicate that the project’s rate of return could be lower than expected, but its contribution to the overall value of the company is high. IRR will also tend to give a higher rating to shorter projects, undervaluing projects that return their value over the long term.
Choosing the right method for your needs
Each of these methods has its advantages and drawbacks, so generally more than one is used for any given project! Furthermore, a qualitative assessment is equally important for a major project. For example, a project may not have the desirable return, but you might decide to go forward with it anyway because of its impact on the business’s long-term plan.