Database Reference
In-Depth Information
Although a popular investment appraisal method, payback period only qualifies as a first screening
technique to initially appraise a project. Its scope is limited to the period the investment is recov-
ered; hence, it ignores potential benefits as a result of investment gains or shortfalls thereafter.
3.1.2 Accounting Rate of Return on Investment (ROI)
This method calculates the return of investment (ROI) by calculating the resulting cash inflows
(produced by the investment) for depreciation. The investment inflows are totaled and the invest-
ment costs are subtracted to derive the profit. The profit is divided by the number of years invested,
and then by the investment cost, to estimate the annual rate of return.
An ROI analysis calculates the difference between the stream of benefits and the stream of
costs over the lifetime of the system discounted by the applicable interest rate. In order to find the
ROI, the average net benefit has to be calculated:
−
−
TotalBenefitsTotal CostsDepreciation
Useful Life
=
NetBenefits
leading to
NetBenefits
InitialInvestment
=
ROI
3.1.3 Net Present Value (NPV)
The Net Present Value (NPV) approach calculates the amount of money that an investment is
worth, taking into account its costs, earnings, and time value of money (inflation). Thus, it com-
pares the economic value of a project today with the value of the same project in the future, taking
inflation and returns into account. If the NPV of a prospective project is positive, it should be
accepted. If the NPV is negative, the project should probably be rejected because the resulting cash
flows will also be negative.
First, the present value is calculated as
(
)
+
−
n
11 interest
Interest
Payment
=
Leading to
(
)
=
Netpresent valueNPV
PresentValue of Expected Cash Value-InitialInvestmentCosts
3.1.4 Cost-Benefit Ratio
This calculation method views the total benefits of an investment over the costs consumed to
deliver these benefits:
TotalBenefits
TotalCosts
=
Cost-Benefit Ratio
