Question

Describe NPV, IRR, ARR and Payback Period In a brief paragraph or a few sentences for each method. These are the 4 most common methods to evaluate capital projects.

Answer 1

1. Net Present Value (NPV) : It can be defined as the Present Value of Cash inflows less the  Present Value of Cash outflows within a time period. When the Net Present Value is positive then the project or investment for which capital budgeting excercise is done should be accepted. Whereas a negative NetPresent Value shows that it would not be viable to accept the project or make the investment.

2. Internal Rate of Return (IRR) : It is the interest rate at which Net Present Value of a project or investment will be equal to zero. It can be also defined as the interest rate at which Present Value of future cash flows will be equal to the cost paid for the project or investment.

3. Accounting Rate of Return (ARR) : The expected profit an individual can make on his average investments is knwon as Accounting Rate of Return.ARR is given by (Average Profit / Average Investment) * 100

Where Average Profit refers to the average of profits during the life of project.

Average Investment refers to Average of begining and ending book value of the project.

4. Payback Period : It refers to the period in which the initial costs incurred for the project can be recovered or it can be defined as how much time it will take to get back the inital amount invested in the project. Payback period does not takes into account the Time Value of Money.