Making Investment Decisions

In practice, no single investment appraisal method provides a complete picture. Businesses typically use multiple methods — payback, ARR, and NPV — alongside non-financial considerations to make investment decisions. This lesson brings together the three quantitative methods, examines how they should be used in combination, and explores the qualitative and strategic factors that influence real-world investment decisions.

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Comparing the Three Methods

Feature	Payback Period	Average Rate of Return (ARR)	Net Present Value (NPV)
What it measures	Time to recover investment	Annual profitability (%)	Value created in today's money (£)
Decision rule	Shorter = better	Higher % = better	Positive = accept; higher = better
Time value of money	Ignored	Ignored	Accounted for
Cash flows after payback	Ignored	Included	Included
Basis	Cash flow	Profit	Discounted cash flow
Ease of calculation	Very simple	Simple	More complex
Ease of understanding	Very intuitive	Intuitive	Less intuitive
Theoretical rigour	Low	Moderate	High
Best used for	Risk/liquidity assessment	Profitability comparison	Value creation assessment

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Using Methods Together: A Comprehensive Worked Example

A business is choosing between two projects. The discount rate is 10%.

Discount factors at 10%:

Year	Discount Factor
0	1.000
1	0.909
2	0.826
3	0.751
4	0.683
5	0.621

Project X — Initial Investment: £300,000

Year	Net Cash Flow (£)	Cumulative (£)	Discount Factor	Present Value (£)
0	(300,000)	(300,000)	1.000	(300,000)
1	120,000	(180,000)	0.909	109,080
2	120,000	(60,000)	0.826	99,120
3	100,000	40,000	0.751	75,100
4	60,000	100,000	0.683	40,980
5	40,000	140,000	0.621	24,840

Payback: Occurs during Year 3. Amount needed at start of Year 3 = £60,000. Year 3 cash flow = £100,000. Payback = 2 years + (60,000 ÷ 100,000) × 12 = 2 years and 7.2 months

ARR:

• Total cash inflows = £440,000
• Total profit = £440,000 − £300,000 = £140,000
• Average annual profit = £140,000 ÷ 5 = £28,000
• ARR = (£28,000 ÷ £300,000) × 100 = 9.3%

NPV: Sum of present values = (300,000) + 109,080 + 99,120 + 75,100 + 40,980 + 24,840 = £49,120

Project Y — Initial Investment: £300,000

Year	Net Cash Flow (£)	Cumulative (£)	Discount Factor	Present Value (£)
0	(300,000)	(300,000)	1.000	(300,000)
1	40,000	(260,000)	0.909	36,360
2	60,000	(200,000)	0.826	49,560
3	100,000	(100,000)	0.751	75,100
4	120,000	(20,000)	0.683	81,960
5	150,000	130,000	0.621	93,150

Payback: Occurs during Year 5. Amount needed at start of Year 5 = £20,000. Year 5 cash flow = £150,000. Payback = 4 years + (20,000 ÷ 150,000) × 12 = 4 years and 1.6 months

ARR:

• Total cash inflows = £470,000
• Total profit = £470,000 − £300,000 = £170,000
• Average annual profit = £170,000 ÷ 5 = £34,000
• ARR = (£34,000 ÷ £300,000) × 100 = 11.3%

NPV: Sum of present values = (300,000) + 36,360 + 49,560 + 75,100 + 81,960 + 93,150 = £36,130

Comparison

Criterion	Project X	Project Y	Preferred
Payback	2 years 7 months	4 years 2 months	Project X
ARR	9.3%	11.3%	Project Y
NPV	£49,120	£36,130	Project X

The methods disagree. Project X has a faster payback and higher NPV, but Project Y has a higher ARR. This is because Project Y generates more total profit but its cash flows arrive later — reducing their present value.

Which Project Should Be Chosen?

This depends on the business's priorities: