When making capital investment decisions, companies need to carefully evaluate potential projects. There are several commonly used evaluation methods, each with their own strengths and weaknesses. The straight line method is one such approach. This article will provide an overview of straight line investments and compare it to other methods like accounting rate of return, payback period, net present value, and internal rate of return. We will look at the pros and cons of each, and when straight line investments may or may not be the best option. With large investments at stake, it is critical that companies utilize the optimal evaluation technique to support smart capital allocation and maximizing shareholder value.
Overview of straight line investments method
The straight line investments method calculates depreciation expense by allocating the cost of an asset evenly over its estimated useful life. It is the simplest and most commonly used approach. Under straight line depreciation, the annual depreciation expense equals the cost of the asset minus the salvage value, divided by the useful life. This results in a constant depreciation expense each year over the asset’s life. The key advantage of straight line depreciation is its simplicity. It is easy to calculate and understand. However, a drawback is that it does not reflect an asset’s actual economic usage and decline in value over time. The straight line method assumes the asset depreciates equally each year, which is often not realistic.
Accounting rate of return evaluation method
The accounting rate of return (ARR) method focuses on an investment’s performance as measured by accounting income and accounting values. It is calculated as the average annual accounting profit from a project divided by the average investment over the project’s life. A strength of ARR is its close link to return on capital employed, which enhances credibility. Also, it is easy for accountants to understand since it uses familiar accounting measures. However, ARR does not consider the time value of money or properly rank projects of different sizes. It can also be manipulated through accounting policy choices.
Payback period evaluation method
The payback period measures how long it takes for a project to recoup its initial investment from its cash inflows. It is easy to understand and useful for assessing liquidity risk. However, payback ignores the time value of money and cash flows after the payback point. It also does not properly account for project scale. Still, despite its flaws, payback period is a quick, basic risk measure that continues to be used in practice.
Net present value (NPV) evaluation method
NPV explicitly considers the time value of money by discounting a project’s expected future cash flows to the present. It provides the project’s impact on shareholder wealth in dollar terms. A strength of NPV is that it accounts for all relevant cash flows over a project’s life. However, NPV does not reveal the actual return percentage, nor does it allow ranking projects of different sizes. If funds are limited, selecting projects solely based on highest NPV may not maximize value.
Internal rate of return (IRR) evaluation method
IRR reveals the expected return of an investment as an interest rate percentage. Like NPV, it considers the time value of money and all relevant cash flows. However, IRR can be difficult to compute manually. It may also conflict with NPV in ranking certain projects. Unusual cash flow patterns can result in multiple IRRs. Since IRR focuses on return percentage, it does not properly account for project scale differences.
In summary, each capital investment evaluation method has pros and cons. Straight line investments provide a simple way to allocate asset costs over time, but do not reflect economic reality. When selecting between potential projects, companies should utilize multiple techniques like payback, ARR, NPV and IRR to support optimal decision making.