In this way, the appraisal methods help organizations to choose the most profitable and feasible project from a pool of numerous projects. Selection of right project is highly critical for the financial well-being of any organization. The organization has to make huge investment at the beginning in order to get good return over a long period of time. Poor appraisal of any project may lead under-investment (which results in underutilization of organization’s resources leading to decline in market position) or over-investment (which causes excessive strain on organization’s resources, expenses exceed the income).
There are mainly two methods of appraisal.
1. Discounting Methods: Time value of money is considered
There are two techniques of discounting.
a. Net Present Value (NPV):
Here the present value of the future cash flows is calculated and compared with the cost of investment. If the present value exceeds investment, project is accepted otherwise it is rejected.
b. Internal Rate of Return (IRR):
IRR is the rate of return at which the NPV of the investment becomes zero. If IRR is greater than the cost of investment (rate of borrowing money), project is accepted otherwise it is rejected.
2. Non-discounting Methods: Time value of money is not considered
Under this there are two techniques.
a. Payback Method:
Here the number of years required to recover the initial investment is calculated for all the available projects. The one with smallest figure is chosen.
b. Average Rate of Return (ARR):
ARR measures the profit derived from total income as a percentage of total investment cost for all the available projects and the one with higher returns is selected.