Choosing the right investment projects is crucial for getting good returns. There are several methods to evaluate projects, including accounting rate of return, payback period, net present value and internal rate of return. Each has its own strengths and weaknesses. Key factors to consider include expected cash flows, timing of cash flows, required rate of return, and whether projects are independent or mutually exclusive. It’s also critical to choose industries and sectors with strong growth potential. Information technology, healthcare and consumer sectors are attractive now. Proper project analysis and selection sets the foundation for investment success.
Accounting rate of return focuses on accounting profitability but ignores time value of money
The accounting rate of return (ARR) method relates accounting profit to the book value of assets. It’s easy to understand and uses familiar accounting measures. However, ARR doesn’t consider the time value of money or properly rank competing projects. It can also be manipulated through accounting policies.
Payback period indicates liquidity but lacks time value of money concept
The payback period measures how long it takes to recover the initial investment. It’s simple to calculate and understand. Payback analysis highlights liquidity risk. But it ignores the time value of money and cash flows after the payback point. There is also no definitive standard for an acceptable payback period.
Net present value fully captures time value of money and all cash flows
The net present value (NPV) method discounts all expected future cash flows to the present. It explicitly considers the time value of money and cash flows over the entire project life. Positive NPV projects increase shareholder wealth. However, NPV doesn’t directly give a return percentage or rank independent projects.
Internal rate of return shows return percentage but has limitations
The internal rate of return (IRR) sets NPV equal to zero to give a return percentage. It has similar strengths as NPV. However, IRR has difficulties with unusual cash flow patterns and ranking mutually exclusive projects. It also depends on reinvestment rate assumptions.
There are tradeoffs between different capital budgeting techniques. NPV is theoretically sound but payback period indicates risk. Using multiple methods together leads to better project selection. The most critical success factor is identifying high growth industries with sustainable competitive advantages.