The Npv Rule Is the Best Investment Appraisal Method

2521 Words Oct 9th, 2007 11 Pages
Investment decisions are essential for a business as they define the future survival, and growth of the organisation. The main objective of a business being the maximisation of shareholders' wealth. Therefore a firm needs to invest in every project that is worth more than the costs. The Net Present value is the difference between the project's value and its costs. Thus to make shareholders happy, a firm must invest in projects with positive NPVs. We shall start this essay with an explanation of the NPV, then compare this method with other investment appraisal methods and finally try to define, based on the works of Tony Davies, Brian Pain, and Brealey/Myers/Allen, which method works best in order to define a good investments.

So what is
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For example if the cut-off date is two years, project A although clearly the most profitable on the long term will be rejected. Thus if a firm uses the same cut-off regardless of project life then it will tend to accept many poor short lived projects and reject many good long lived ones.

Accounting rate of return

The accounting rate of return (ARR) is a simple measure sometimes used in investment appraisal. It is a form of return on capital employed. ARR is calculated in the following way:

ARR= average accounting profit over the project x 100% Initial investment

We here see that ARR is based on profits rather than cash flows and that it ignores the time value of money. It therefore just gives a brief overview of a new project, and should not be recommended as a primary investment appraisal method. As said earlier the impact of cash flows and the time value of money are essential in making an investment decision. Another disadvantage of the ARR is the fact it is dependent on the depreciation policy adopted by the business.

Internal Rate of
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