Investment appraisal
Methods and cash flows
Investment appraisal compares incremental cash flows. NPV discounts all relevant cash flows at the project's opportunity cost of capital and is preferred because it measures absolute value added. IRR is the discount rate giving zero NPV; it is useful for comparing projects but can mislead with non-conventional cash flows or differing scales. Payback measures liquidity and risk recovery time, not profitability; ARR uses accounting profit and ignores timing. Relevant flows are future, incremental and cash. Exclude sunk costs, allocated head-office overheads not caused by the project, and financing cash flows if the discount rate already reflects financing. Include tax, capital allowances, working-capital investment and recovery, and disposal proceeds.
Inflation and risk
Use nominal cash flows with a nominal discount rate or real cash flows with a real rate; never mix. Tax is usually paid in arrears, so timing matters. Risk can be assessed by sensitivity, scenario, simulation or risk-adjusted discount rates. Capital rationing requires ranking by profitability index when projects are divisible; otherwise use trial-and-error combinations.
Traps and rule of thumb
Traps: discounting profit instead of cash; forgetting working-capital recovery; deducting interest when using WACC; using IRR ranking for mutually exclusive projects of different size. Rule of thumb: if NPV is positive, accept; if choosing between mutually exclusive projects, choose the highest positive NPV, not the highest IRR.
Worked example: a machine costs $100,000 and generates $40,000 annually for three years; discount rate 10%. Annuity factor 2.487, PV $99,480, NPV negative $520. Reject, because value is slightly destroyed.