Introduction
When evaluating capital investment proposals, I often encounter two broad categories of analysis: those that incorporate present value principles and those that ignore them. While net present value (NPV) and internal rate of return (IRR) are widely used in financial decision-making, many businesses still rely on simpler methods that disregard time value considerations. In this article, I will explore these methods in depth, discuss their strengths and weaknesses, and demonstrate their application through practical examples.
Why Some Methods Ignore Present Value
Ignoring present value in investment evaluation simplifies decision-making, especially for businesses that prioritize quick calculations over complex discounted cash flow (DCF) analyses. Many small and medium-sized businesses use these techniques because they require minimal financial expertise and are easy to interpret. However, the trade-off is a lack of accuracy in long-term capital investment decisions.
Methods of Evaluating Capital Investment Proposals That Ignore Present Value
1. Payback Period Method
Definition and Formula
The payback period is the time it takes for an investment to recover its initial cost through cash inflows. It is calculated using the formula:
Payback \ Period = \frac{Initial \ Investment}{Annual \ Cash \ Inflow}Example Calculation
Suppose a company invests $50,000 in new machinery that generates $10,000 in annual cash inflows. The payback period would be:
Payback \ Period = \frac{50,000}{10,000} = 5 \ yearsThis means the investment will be recovered in 5 years.
Advantages
- Simple to calculate and understand
- Useful for assessing liquidity risk
- Ideal for businesses with limited investment budgets
Disadvantages
- Ignores cash flows beyond the payback period
- Does not account for the time value of money
- Favors short-term investments over long-term profitability
2. Accounting Rate of Return (ARR)
Definition and Formula
The accounting rate of return measures profitability by comparing average annual accounting profit to the initial investment. It is calculated as:
ARR = \frac{Average \ Annual \ Accounting \ Profit}{Initial \ Investment} \times 100Example Calculation
A company invests $100,000 in a project that yields an average annual accounting profit of $20,000. The ARR would be:
ARR = \frac{20,000}{100,000} \times 100 = 20%Advantages
- Easy to compute using accounting data
- Considers profitability rather than cash flow
- Allows direct comparison with required rates of return
Disadvantages
- Ignores time value of money
- Uses accounting profits rather than cash flows
- Can be distorted by different accounting policies
3. Return on Investment (ROI)
Definition and Formula
Return on investment measures the efficiency of an investment relative to its cost. It is calculated as:
ROI = \frac{Net \ Profit}{Cost \ of \ Investment} \times 100Example Calculation
A business invests $150,000 in a project that generates a net profit of $30,000. The ROI would be:
ROI = \frac{30,000}{150,000} \times 100 = 20%Advantages
- Simple and widely understood metric
- Helps in comparing different investments
- Useful for benchmarking performance
Disadvantages
- Ignores time value of money
- Does not consider project duration
- Can be influenced by accounting adjustments
Comparison of Methods
| Evaluation Method | Considers Time Value? | Focuses on Cash Flow? | Ease of Use |
|---|---|---|---|
| Payback Period | No | Yes | High |
| ARR | No | No (uses accounting profit) | Medium |
| ROI | No | No (uses net profit) | High |
Practical Considerations in Choosing a Method
In my experience, businesses often choose these methods based on their specific needs:
- Payback Period is suitable for liquidity-focused decisions.
- ARR works well for managerial decision-making where profitability is the main concern.
- ROI is useful for comparing multiple investments within a portfolio.
Conclusion
While methods that ignore present value offer simplicity and quick decision-making, they come with limitations that can lead to suboptimal investment choices. In situations where long-term profitability is critical, I always recommend supplementing these methods with present value-based approaches for a more accurate assessment. However, for businesses looking for quick evaluations, these traditional methods remain valuable tools.
