Chapter 9: Investment Appraisal

• What is investment appraisal?

  A technique used to evaluate planned investment by a business and measure its potential value of the business.
• Methods of investment appraisal

  • Payback period
  • Average rate of return (ARR)
  • Discounted cash flow
• What is payback period?

  The time it takes for the project to pay back its initial value
• Payback period formula

  Income needed in period / contribution per month
• Benefits of payback period

  • Easy to calculate and easy to use
  • Helps manage cash flow
  • Considers timing of cash flows
• Drawbacks of payback period

  • Ignores what happens after the payback period
  • May encourage a short term attitude
  • Ignores total profitability (focuses more how quickly they repay the project)
• What is Average rate of return?

  Measure of the gain or loss on an investment over a specified period, expressed as a percentage of the initial investment.
• ARR formula

  (average annual rate / initial outlay) x 100
• Benefits of ARR

  • Uses all the cash flow over life of the project
  • Focuses on profitability
  • Easy to make comparisons
  • Allows comparison with costs of borrowing for investment
• Drawbacks of ARR

  • Ignores timings of the cash flows
  • Does not allow for effects of inflation on values of future cash flows
• What is New present value (NPV)?

  Used to calculate the current value of a future stream of payment from a company, project, or investment
• Benefits of NPV

  • Allows for future earnings to be adjusted to present values
  • easy to compare different projects
  • Allows for impact of inflation on value of future cash flows
  • Can be changed to accommodate changes in the economic and financial climate
• Drawbacks of NPV

  • Complex to calculate
  • Interest rates estimations over time period may be inaccurate
  • not useful for comparing projects of different sizes, as the largest projects typically generate highest returns
• NPV formula

  (NPV / initial investment) x 100