Commonly used investment valuation techniques are accounting rate of return, payback period, discounted payback period, internal rate of return, and net present value.
Now let’s look at the short definitions of these techniques.
- Accounting rate of return (ARR)
This technique is also called as return on capital employed (ROCE) or return on investment (ROI). It relates accounting profit to the capital invested.
ARR = (Average annual profit / Average investment outlays) x 100%
- Payback Period (PP)
This technique measures the shortest time to recover the initial investment outlay from the cash flows generated from the investment. A firm will accept an investment if the PP is less than or equal to a target period.
- Discounted Payback Period (DPP)
This technique is similar to paypack period except that the cash flows from the investment are first discounted to time 0 and the shortest time to recover the initial investment outlay will then be measured.
- Internal rate of return (IRR)
IRR on an investment or project is the annualised effective compounded return rate or discount rate that makes the net present value (NPV) of all cash flows (both positive and negative) generated from a particular investment equal to zero. The decision rule is to accept a project or investment if its IRR is higher than the cost of capital.
- Net Present Value (NPV)
NPV combines the present values of all future cash flows and compares the total to the initial investment. If the NPV of a project is positive, it indicates that it earns a positive return over the cost of capital and will therefore increase the shareholders’ value. A firm should invest in all positive NPV projects, so the market value of the firm will increase by the total of the NPVs, once they are announced to the market.