Three ways to decide whether a big purchase is worth it — and why the simplest one is the most used and least reliable.
Methods for judging whether an investment pays for itself, and how they disagree.
Payback period — how long until the investment returns its cost. Simple, intuitive, and it ignores everything that happens after payback and the fact that money has a time value. Widely used because it answers the question owners actually ask: when do I get my money back?
Average rate of return (ARR) — average annual profit as a percentage of the initial investment. Uses all the years and expresses the result as a percentage that can be compared with other options. Still ignores timing.
Net present value (NPV) — future cash flows discounted back to what they are worth today, minus the initial cost. A positive NPV means the investment beats the discount rate. The most rigorous of the three.
£1,000 in five years is worth less than £1,000 today — you could have invested it, and there is risk it never arrives. NPV is the only one of the three that takes this seriously, which is why a project can have a decent payback and a negative NPV.
The numbers are only as good as the forecast cash flows. Sophisticated arithmetic on invented figures produces confident nonsense, which is the main way investment appraisal goes wrong in practice.
Calculate, then say which method suits the business's situation and why. A cash-poor firm may rationally prefer payback despite NPV being technically superior.