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Investment Appraisal Techniques: NPV, IRR, Payback and ARR for SBL

Updated 11 October 2026 · Fact-checked

Investment appraisal tests whether a capital project is worth doing. NPV discounts cash flows at the cost of capital and accepts positive values. IRR is the discount rate giving NPV of zero. Payback measures time to recover cash. ARR compares accounting profit with investment. In SBL, calculate briefly, then judge the result in context.

Understand Investment Appraisal Techniques (NPV, IRR, Payback, ARR)

A capital project costs money now and pays back over several years. Investment appraisal helps you decide if the future benefits justify the cost. In SBL, the numbers are only part of the answer. You must also advise the board.

There are two groups of methods. Discounted cash flow (DCF) methods, NPV and IRR, allow for the time value of money. Cash received sooner is worth more than cash received later. Non-discounted methods, payback and ARR, ignore this.

NPV adds up all future cash flows after discounting them to today's value, then subtracts the initial outlay. A positive NPV means the project earns more than the required return and adds value to shareholders. IRR finds the discount rate at which NPV is zero. If IRR is above the required return, the project is acceptable.

Payback asks how long it takes to recover the initial investment. It is simple and shows liquidity and risk, but it ignores cash flows after the payback point. ARR divides average annual accounting profit by the investment. It uses profit, not cash, so it is affected by depreciation policy.

In SBL you rarely get a pure calculation. You get a case, a few numbers and a task such as advising the board. Calculate quickly, then discuss strengths, weaknesses, risks, assumptions and non-financial factors. That discussion earns the professional skills marks for analysis and commercial acumen.

Key rules to remember

Net present value: NPV = Σ [CFt ÷ (1 + r)^t] − initial investment; CFt is the net cash flow in year t and r is the cost of capital. Accept if NPV > 0.
Internal rate of return (interpolation): IRR ≈ L + [NPV_L ÷ (NPV_L − NPV_H)] × (H − L); L and H are two discount rates, one giving a positive NPV and one a negative NPV. The result is an estimate. Accept if IRR > cost of capital.
Payback period: Payback = full years before recovery + (unrecovered cost at start of year ÷ cash flow in that year); Assumes cash flows arise evenly through the year. Uses cumulative cash flows.
Accounting rate of return: ARR = average annual accounting profit ÷ initial investment × 100%; An alternative uses average investment = (initial cost + residual value) ÷ 2. State which you use.
Annuity of a constant cash flow: PV = cash flow × annuity factor; Use the factor from the tables ACCA provides for the rate and number of years.
Decision rules: NPV > 0 accept; IRR > r accept; payback ≤ target accept; ARR ≥ target accept; Payback and ARR targets are set by management.

How to solve Investment Appraisal Techniques (NPV, IRR, Payback, ARR) questions

Use this order for any investment appraisal requirement in SBL. Keep the workings short and spend your time on advice.

1Read the requirement. Note which methods are asked for and who the audience is, such as the board or a non-finance director.
2List only relevant cash flows: incremental, future and cash-based. Exclude sunk costs, allocated overheads and depreciation (for NPV, IRR and payback).
3Add tax, working capital and inflation effects only if the case gives them. Keep timing consistent.
4Discount at the cost of capital given. Calculate NPV, and IRR if asked, using two rates for interpolation.
5Calculate payback from cumulative cash flows and ARR from accounting profit, as required.
6Compare results with decision rules, and explain if the methods give conflicting signals.
7Discuss limitations and assumptions: forecast reliability, cost of capital, risk, project life and non-financial factors.
8Finish with a clear recommendation and any further information needed.

Quickest way: Table, decide, then discuss

When to use it: Use when time is short and the case contains only a few years of cash flow data.

Draw one table with years across and rows for cash flows, discount factor and present value.
Calculate NPV first. It is the most reliable measure and often the only one needed.
If IRR is asked, pick a second rate close to where NPV changes sign, to keep interpolation error small.
Calculate payback from a cumulative cash flow row in the same table.
Write the recommendation sentence early, then add two strengths and two weaknesses of each method used, linked to the case.

Common mistakes in Investment Appraisal Techniques (NPV, IRR, Payback, ARR)

Including depreciation or sunk costs in cash flows for NPV.
Students copy profit figures straight from the case.
Fix: Use cash flows only. Remove depreciation and past costs, and include only incremental future cash.
Discounting the initial outlay.
Students apply a factor to every figure in the table.
Fix: Treat the initial investment as year 0 with a factor of 1.000.
Using IRR to rank mutually exclusive projects without checking NPV.
IRR is a percentage, so it looks easy to compare.
Fix: Choose the higher NPV for mutually exclusive projects, because IRR ignores project scale and can mislead.
Listing textbook advantages and disadvantages with no link to the case.
Students memorise lists to save time.
Fix: Tie each point to the scenario, such as uncertain forecasts, a cash-constrained company or a long project life.
Calculating payback from annual cash flows instead of cumulative ones.
Students rush and lose track of the balance outstanding.
Fix: Always write the cumulative cash flow row and find where it turns positive.
Stopping at the number and giving no recommendation.
Students treat the question as a calculation exercise.
Fix: State accept or reject, give reasons, and mention risks and non-financial factors for the professional skills marks.

Worked examples

Example 1

A company is considering a project costing $200,000 now. It is expected to generate net cash inflows of $80,000 in each of years 1 to 4. The cost of capital is 10%. The 4-year annuity factor at 10% is 3.170. Calculate the NPV and payback period and advise whether to accept.

Show the solution

PV of inflows = $80,000 × 3.170 = $253,600.
NPV = $253,600 − $200,000 = $53,600.
Cumulative cash flows: year 1 = $80,000, year 2 = $160,000, year 3 = $240,000.
Cost is recovered during year 3. Unrecovered at start of year 3 = $200,000 − $160,000 = $40,000.
Payback = 2 + ($40,000 ÷ $80,000) = 2.5 years.
NPV is positive, so the project earns more than the 10% required return. Payback is 2.5 years in a 4-year project, so cash is recovered with a margin.

Answer: NPV = $53,600 and payback = 2.5 years. Accept the project, subject to checking forecast reliability and the sensitivity of the cash flows.

Example 2

A project costs $100,000 and has no residual value. It earns annual accounting profits (after depreciation) of $10,000, $20,000, $30,000 and $20,000 over four years. The company's target ARR is 25% on initial investment. Calculate the ARR and comment on its use.

Show the solution

Total profit = $10,000 + $20,000 + $30,000 + $20,000 = $80,000.
Average annual profit = $80,000 ÷ 4 = $20,000.
ARR on initial investment = $20,000 ÷ $100,000 × 100% = 20%.
20% is below the 25% target, so the project fails on this measure.
Comment: ARR uses profit, not cash, ignores timing and depends on depreciation policy. It should be used alongside NPV, not alone.

Answer: ARR = 20%, below the 25% target, so the project is rejected on ARR alone. Because ARR ignores the time value of money, the board should also review NPV before deciding.

Exam tips

Show a short working table. Markers give credit for correct method even if one figure is wrong.
State your assumptions in one line each, such as end-of-year cash flows and the cost of capital used.
Always compare methods when they disagree. NPV and IRR can conflict for mutually exclusive projects, and NPV is preferred.
Link limitations to the case: uncertain forecasts, capital rationing, risk and strategic fit.
End with a recommendation addressed to the reader named in the requirement, in clear professional language.

Practice questions from Financial analysis and decision-making techniques

Investment Appraisal Techniques (NPV, IRR, Payback, ARR) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Investment Appraisal Techniques (NPV, IRR, Payback, ARR): frequently asked questions

What is the difference between NPV and IRR?

NPV gives the absolute value added in money terms at the required rate of return. IRR gives the return as a percentage, the rate at which NPV is zero. NPV is generally preferred because it shows the size of value created and avoids ranking problems.

Why is NPV considered better than payback and ARR?

NPV uses all cash flows and allows for the time value of money. Payback ignores cash after the payback point and ARR uses accounting profit rather than cash. NPV also links directly to shareholder wealth.

When is payback still useful?

Payback is useful when liquidity matters or forecasts far into the future are unreliable. It is simple to explain to non-finance managers. Use it as a supporting measure, not the only one.

How much calculation should I do in SBL?

Do enough to support your advice, usually a short table. The exam rewards analysis, judgement and recommendations more than long workings. Spend most of your time explaining what the results mean for the business.