Appraise a capital investment using the payback period, the accounting rate of return, net present value and the internal rate of return, recognising the role of the time value of money and the strengths and limitations of each method.

What this dot point is asking

The SQA wants you to appraise a long-term (capital) investment using four techniques and to judge between them. Two are simple and ignore the timing of money - payback and accounting rate of return - and two account for the time value of money - net present value and internal rate of return. You must calculate each, make a recommendation, and discuss strengths and limitations.

The non-discounting methods

Payback and ARR are quick screens, valued for simplicity but flawed because they treat a pound today the same as a pound in five years.

Payback answers "how soon do we get our money back?", which matters when cash or risk is a concern, but it ignores everything after the payback point and the timing within it. ARR uses accounting profit (after depreciation), so it links to reported performance, but it also ignores the timing of returns and can be defined on initial or average investment, so state which you use.

The time value of money and NPV

The discounting methods rest on one idea: money has a time value.

Net present value discounts every future cash flow to today, sums them, and subtracts the initial outlay. A positive NPV means the project earns more than the required return and adds value, so it is accepted; a negative NPV means it should be rejected. NPV is the most rigorous method because it uses cash, reflects timing, and gives a clear accept-or-reject rule.

The internal rate of return

IRR is the discount rate that makes the project exactly break even in present-value terms.

A project is accepted if its IRR is above the firm's required return, because it then has a positive NPV at that required rate. IRR is intuitive as a percentage return, but it can be awkward with unconventional cash flows and can rank mutually exclusive projects differently from NPV, in which case NPV is preferred.

Choosing a method and the limitations

A strong answer compares the methods rather than treating them in isolation. Payback is a useful risk screen but ignores later cash and timing. ARR links to reported profit but ignores timing and uses profit not cash. NPV is theoretically the soundest. IRR is a useful percentage but can mislead between projects. All four depend on estimated future cash flows, which are uncertain, and none captures non-financial factors such as strategic fit, staff impact or environmental effect, which must temper the decision.

Why this matters later

Investment appraisal applies the relevant-cash-flow discipline of the decision-making topic to the long term, and its cash-flow forecasts share the timing logic of the cash budget. Its outputs feed strategic decisions a business reports on, linking back to the financial accounting picture of performance and position. The recurring message is that better techniques use cash and reflect timing, but judgement and non-financial factors still decide.

Try this

Q1. A project costs GBP 60,000 and returns GBP 20,000 per year. State the payback period. [2 marks]

• Cue. $\dfrac{60{,}000}{20{,}000} = 3$ years.

Q2. A cash flow of GBP 40,000 is received in two years. The discount factor at 8% for year 2 is 0.857. State its present value. [2 marks]

• Cue. $40{,}000 \times 0.857 = 34{,}280$.