Project Investment Appraisal

JK Products, Inc. is in a tradeoff between 2 projects. The projects are – Project Status Quo (SQ), and Project High Tech (HT). The company can choose only one of the 2 projects in order to enhance its production capabilities. Both projects are equally risky. Therefore, a detailed investment appraisal is necessary to find out which project would be more profitable for JK Products, Inc. as a result, this paper will make use of different investment analysis techniques to find out the optimum project for the company.
Comparison of the Projects
In order to compare both projects, we will calculate their Accounting Rate of Return, Payback Period, Profitability Index, Internal Rate of Return, and Net Present Value. In addition to that, we will also show the NPV Profile of both projects. The summary of our calculations are shown in the sections below. All the formulas and calculations are provided in Appendices.
Accounting Rate of Return (ARR)
According to Helbæk, Lindest and McLellan (2010), ARR is the return or profit a company or an investor can anticipate from an investment. Elmendorf (2011) said that ARR calculates the expected rate of return by dividing the average accounting profit by the investment made at the starting point of the project. It should be noted here that ARR ignores the ‘time value of money’ as well (Easton and Monahan, 2016). The ARR’s of both projects are shown below-
SQ (ARR) = 25.62 %
HT (ARR) = 29.26 %
Here, we can see that project HT has a higher ARR compared to project SQ.

Payback Period (PP)
PP is the time or period an investment requires for recovering its initial investment (Investopedia, 2016). Just like ARR, PP also ignores time value of money (Martin, 2005).
The PP of the 2 projects are given below:
SQ (PP) = 3.90 years
HT (PP) = 3.42 years
Here, we can see that project HT requires less time to recover its initial investment or to reach the break-even point.
Net Present Value (NPV)
Hawawini and Viallet (2011) said that Net present value or NPV is a very important capital budgeting decision making tool that calculates the difference between the present values of all the cash inflows of an investment or a project, and its initial cash outflow. It shows how profitable an investment option is (Pfeiffer, 2004).
The NPVs of both projects are-
Project SQ (NPV) = $ 87,314
Project HT (NPV) = $ 142,254
So, we can see that if the required rate of return or discount rate is 11%, then Project HT is the more preferable option.
Internal Rate of Return (IRR)
Osborne (2011) mentioned that IRR or internal rate of return is a very important tool in evaluating different investment options because it measures how profitable the investment options are. IRR is actually the required rate of return or the discount rate, which makes the NPV of all the cash flows generating from an investment equal or close to ‘zero.’ IRR is calculated using the same formula as the NPV. Taking 16% as the appropriate discount rate for both projects, we get the following IRRs-
Project SQ (IRR) = $ 997.82
This is the closest to zero for project SQ at 16 percent discount rate. Any rate (even 16.1 percent) beyond that results in negative NPV values.
Project HT (IRR) = – $ 21,463.36
At 16% discount rate, we get a negative NPV for project HT. But at 15.1% discount rate, this project’s NPV is $1,928.49 that is the closest value to zero.
So, in terms of the IRR calculation above, Project SQ is the preferred option since it has a higher IRR.
Profitability Index (PI)
Profitability Index or PI finds out the link between the benefits and the costs of a project or an investment by using the PI ratio (Lee and DeVoe, 2012). If the PI ratio of a project is 1.0, that means it is the least acceptable project or investment. According to Magni (2015), anything lower than 1 is not acceptable at all because such a PI would signal that the PV of all the cash inflows of that investment is lower than its cash outflows in the beginning or the initial investment. As a result, investment options or projects with higher PI’s are always more desirable. So both SQ and HT’s PI’s are shown below-
Project SQ (PI) = 1.13
Project HT (PI) = 1.15
We can see that project HT’s PI is slightly higher compared to the PI of project SQ.
Final Decision
Depending on the findings of the 5 different project evaluation techniques, we can conclude that project HT tops project SQ in every aspect except the IRR calculation. As a result, Project HT should be the preferred investment option for JK Products, Inc.
Comparison between NPV, IRR, ARR, PI, and PP
Brief (1999) mentioned that projects with multiple cash flows and changing discount rates can be easily evaluated with NPV, while IRR and PI fail to take these differences into account. However, NPV, PI, and IRR calculations take the risks and the time value of money of an investment option into consideration. Payback Period, on the other hand, is a very simple measure that shows how long it would take a project to reach the break-even point. But it ignores the cash flows, which take place after the PP, and the time value of money is also ignored here. Finally, it is very easy to calculate and understand the ARR, and it shows the profitability of an investment. But it does not consider the terminal value and the time value of money of the investment options (Hillier, 2010). So, from the above discussion, we can come to the decision that it would be wise to use NPV to evaluate most projects, since it overcomes the drawbacks of the other evaluation methods like IRR, ARR, PI, and PP (Dash, 2016).
News Release
From Jackson Cooper
Manager, Finance Department
JK Products, Inc.
To the Shareholders of the corporation
December 31, 2016
Subject: Approving Project High Tech (HT) to Enhance the Production Capabilities of the Company
Dear Sir/Madam,
Our Finance department has conducted a comprehensive analysis to find out the most profitable investment opportunity for the company. After analysing to projects (Project SQ and Project HT) using various capital budgeting measures, we highly recommend to approve investing in project HT to increase our production capacities for meeting the growing customer demands. This project requires a one-time initial investment of $940,000. However, project SQ requires only $670,000 as initial investment. But, HT notably outperformed SQ in 4 out of 5 of our investment appraisal measures.
These 2 projects were the best alternatives narrowed down by our Engineering Department, and we can choose only one of them. Therefore, the detailed and methodical financial analysis was conducted on both projects from different perspectives. As mentioned above, HT has been proven to be the best option for the company in terms of Payback Period, Accounting Rate of Return, Net Present Value, and Profitability Index. Moreover, investing in this project will significantly eliminate our production backlogs and will also increase our productivity.
Considering all the facts presented above, I request you to kindly approve this project in our next annual general meeting.
Best regards,
Jackson Cooper
Manager, Finance Department
The NPV Profile of Both Options
The graph below shows the IRR and NPV of both project HT and SQ-

The vertical axis ‘x’ shows the NPV (in USD) and the horizontal axis ‘y’ shows the cost of capital (%).
The graph above shows that NPV and IRR can show different preferences for mutually exclusive projects. Here, while project HT has higher NPV, it has lower IRR as well. This situation leads to ‘scale problem’ and ‘timing problem’ (Penman, 2016). Scale problem occurs when investors apply only IRR as the investment appraisal technique and choose the project that has the highest IRR. But they ignore the fact that this IRR might generate a lower return on the investment as a whole, compared to the investment that has the lower IRR (Business dictionary, 2016). On the contrary, timing problem happens because when investors only choose IRR to evaluate projects, they might end up choosing a project with short-term profitability instead of the one that actually generates higher returns in the long run (Megginson, Smart and Lucey, 2008). The same problem happened in our projects since SQ generates more cash flows in the beginning, but its cash inflows diminish significantly in the later years. We can see the exactly opposite happening in the case of project HT. In this regard, Yaghoubi, Locke, and Gibb, (2012) concluded that it is always wise to use multiple investment appraisal techniques.
Post-audit Review
I do not completely agree with the Chief Accountant. The Post-audit review offers a lot of benefits. First of all, it enables a firm to make adjustments in the projects that are already going on. It also improves the quality of the future investment proposals, as mistakes made in the past are considered in the review and therefore, corrective measure are taken accordingly (Shim, Siegel and Dauber, 2008).
References
Brief, R. (1999). The Accounting Rate of Return as a Framework for Analysis. SSRN Electronic Journal.
Business Dictionary. (2016). What is scale problem? definition and meaning. [online] Available at: http://www.businessdictionary.com/definition/scale-problem.html [Accessed 31 Dec. 2016].
Dash, M. (2016). The Internal Rate of Return Model for Life Insurance Policies. Asian Journal of Finance & Accounting, 8(2), p.70.
Easton, P. and Monahan, S. (2016). Review of Recent Research on Improving Earnings Forecasts and Evaluating Accounting-based Estimates of the Expected Rate of Return on Equity Capital. Abacus, 52(1), pp.35-58.
Elmendorf, R. (2011). Accounting Rates Of Return As Proxies For The Economic Rate Of Return: An Empirical Investigation. Journal of Applied Business Research (JABR), 9(2), p.62.
Hawawini, G. and Viallet, C. (2011). Finance for executives. 1st ed. Mason, Ohio: South-Western Cengage Learning.
Helbæk, M., Lindest, S. and McLellan, B. (2010). Corporate finance. 1st ed. New York: McGraw-Hill.
Hillier, D. (2010). Corporate finance. 1st ed. London: McGraw-Hill Higher Education.
Investopedia. (2016). Payback Period. [online] Available at: http://www.investopedia.com/terms/p/paybackperiod.asp [Accessed 31 Dec. 2016].
Juhász, L. (2011). NET PRESENT VALUE VERSUS INTERNAL RATE OF RETURN. Economics & Sociology, 4(1), pp.46-53.
Lee, B. and DeVoe, S. (2012). Flextime and Profitability. Industrial Relations: A Journal of Economy and Society, 51(2), pp.298-316.
Magni, C. (2015). ROI and Profitability Index: A Note on Managerial Performance. SSRN Electronic Journal.
Martin, R. (2005). Internal Rate Of Return Revisited. SSRN Electronic Journal.
Megginson, W.L., S.J. Smart, B.C. Lucey (2008). Introduction to Corporate Finance. Cengage Learning EMEA.
Osborne, M. (2011). On the Meaning of Internal Rates of Return and Why an Internal Rate of Return is Not an Investment Criterion. SSRN Electronic Journal.
Penman, S. (2016). Valuation: Accounting for Risk and the Expected Return. Abacus, 52(1), pp.106-130.
Pfeiffer, T. (2004). Net Present Value-Consistent Investment Criteria Based on Accruals. SSRN Electronic Journal.
Shim, J., Siegel, J. and Dauber, N. (2008). Corporate controller’s handbook of financial management 2008-2009. 1st ed. Chicago, IL: CCH.
Yaghoubi, R., Locke, S. and Gibb, J. (2012). Net Present Value of Acquisitions. SSRN Electronic Journal.
Appendices
Accounting Rate of Return
The formula for calculating the ARR is as follows-
ARR = Average Accounting Profit / Initial Investment
The ARR’s of both projects are calculated below-
SQ: Average Accounting Profit = $ 1030000 / 6 = $171666.67
ARR = $171666.67 / $ 670,000 = 25.62 %
HT: Average Accounting Profit = $ 1650000 / 6 = $ 275000
ARR = $ 275000 / $ 940,000 = 29.26 %
Payback Period
The formula for calculating the PP is as follows-
Payback Period = Initial Investment / Average Accounting Profit
We will now calculate the PP of the 2 projects using this formula:
SQ: Payback Period = $ 670,000 / $ 171666.67 = 3.90 years
HT: Payback Period = $ 940,000 / $ 275000 = 3.42 years
Net Present Value
The formula for calculating NPV is shown below-
NPV = ∑ {Net Period Cash Flow / (1+R) ^ T} – Cash outflows in the beginning
Here, R = The necessary rate of return, with which all the cash flows are discounted,
And, T = Time
Using this formula, and the given required rate of return (11 percent), we will find out the NPVs of both projects now.
Project SQ (NPV): {250,000 / (1 + 0.11) ^ 1} + {200,000 / (1 + 0.11) ^ 2} + {170,000 / (1 + 0.11) ^ 3} + {150,000 / (1 + 0.11) ^ 4} + {130,000 / (1 + 0.11) ^ 5} + {130,000 / (1 + 0.11) ^ 6} – 670,000
= $ 87,314
Project HT (NPV): {170,000 / (1 + 0.11) ^ 1} + {180,000 / (1 + 0.11) ^ 2} + {200,000 / (1 + 0.11) ^ 3} + {250,000 / (1 + 0.11) ^ 4} + {300,000 / (1 + 0.11) ^ 5} + {550,000 / (1 + 0.11) ^ 6} – 940,000
= $ 142,254
Internal Rate of Return
IRR is calculated using the same formula as the NPV. However, IRR calculation is a bit of a ‘trial and error’ process as it requires calculating the NPV of a project with several discount rates or required rates of return for finding out which rate makes the NPV equal or close to zero.
Let’s take 16% as the suitable rate to discount both projects-
Project SQ (IRR): {250,000 / (1 + 0.16) ^ 1} + {200,000 / (1 + 0.16) ^ 2} + {170,000 / (1 + 0.16) ^ 3} + {150,000 / (1 + 0.16) ^ 4} + {130,000 / (1 + 0.16) ^ 5} + {130,000 / (1 + 0.16) ^ 6} – 670,000
= $ 997.82
This is the closest to zero for project SQ at 16 percent discount rate. Any rate (even 16.1 percent) beyond that results in negative NPV values.
Project HT (IRR): {170,000 / (1 + 0.16) ^ 1} + {180,000 / (1 + 0.16) ^ 2} + {200,000 / (1 + 0.16) ^ 3} + {250,000 / (1 + 0.16) ^ 4} + {300,000 / (1 + 0.16) ^ 5} + {550,000 / (1 + 0.16) ^ 6} – 940,000
= – $ 21,463.36
At 16% discount rate, we get a negative NPV for project HT. But at 15.1% discount rate, this project’s NPV is $1,928.49 that is the closest value to zero.
Profitability Index
The formula below is used in calculating the PI of a project:
PI Ratio: Present Value of Cash Inflows / Initial Investment
So both SQ and HT’s PI’s are calculated below-
Project SQ (PI): {250,000 / (1 + 0.11) ^ 1} + {200,000 / (1 + 0.11) ^ 2} + {170,000 / (1 + 0.11) ^ 3} + {150,000 / (1 + 0.11) ^ 4} + {130,000 / (1 + 0.11) ^ 5} + {130,000 / (1 + 0.11) ^ 6} / 670,000
= 757313.87 / 670,000
= 1.13
Project HT (PI): {170,000 / (1 + 0.11) ^ 1} + {180,000 / (1 + 0.11) ^ 2} + {200,000 / (1 + 0.11) ^ 3} + {250,000 / (1 + 0.11) ^ 4} + {300,000 / (1 + 0.11) ^ 5} + {550,000 / (1 + 0.11) ^ 6} / 940,000
= 1082254.1 / 940,000
= 1.15
The NPV Profile of Both Options
Here, we calculated the NPVs of both projects at different discount rates (required rate of return, 0% – 20%) using the NPV formula. The calculation was done in Excel. The table below shows a synopsis of the Excel calculations-
Year HT SQ
0 ($940,000) ($670,000)
1 170,000 250,000
2 180,000 200,000
3 200,000 170,000
4 250,000 150,000
5 300,000 130,000
6 550,000 130,000
Rate NPV HT NPV SQ
0% $710,000 $360,000
1% $642,698 $328,888
2% $579,206 $299,285
3% $519,265 $271,097
4% $462,633 $244,237
5% $409,090 $218,625
6% $358,430 $194,186
7% $310,465 $170,850
8% $265,021 $148,553
9% $221,935 $127,235
10% $181,059 $106,839
11% $142,254 $87,314
12% $105,391 $68,611
13% $70,352 $50,685
14% $37,025 $33,493
15% $5,307 $16,996
16% ($24,897) $1,157
17% ($53,677) ($14,058)
18% ($81,116) ($28,683)
19% ($107,290) ($42,747)
20% ($132,272) ($56,279)