investment appraisal

• Investment

  Purchase of an asset that will generate future earnings
• Investment appraisal

  A quantitative business management tool used to evaluate whether different investment opportunities or investment projects are worth pursuing
• Investment appraisal techniques

  • Payback period (PBP)
  • Average rate of return (ARR)
  • Net present value (NPV)
• Calculating payback period (PBP)

  1. Initial investment cost / Cash flow from investment per period

  2. Additional cash inflow needed / Annual cash flow in next year * 12 months + Number of full years
• Payback period (PBP)

  • Simple, easy and quick to calculate
  • Helpful for industries where assets get outdated quickly
  • Only considers time, not overall profitability
  • Relies on predicted cash flows which may not be accurate
• Calculating average rate of return (ARR)

  Total returns - Capital costs / Years of use / Capital costs * 100
• Average rate of return (ARR)

  • Can be compared to interest rates and internal benchmark (Criterion rate)
  • Provides a percentage return on the investment
• Criterion rate is an internal benchmark that companies develop to decide minimum acceptable rate of return for investment projects
• ARR (Average Rate of Return)

  Calculated as: Total returns minus Capital costs divided by years of use divided by Capital costs times 100
• Sometimes you will not be given returns, only cash inflows, then you have to subtract the costs to get net cash flows
• After calculating ARR, you have to compare it to interest rate in the banks and to the internal Benchmark (Criterion rate)
• Mind the difference between cash flows and net cash flows/returns
• Calculating ARR for Gelato Maker investment

  1. Calculate total returns

  2. Apply ARR formula

  3. Compare to interest rate and Criterion rate
• ARR as a business tool


  • Simple, easy and quick to calculate
  • Takes account of the entire profitability over the entire lifespan
• Limitations of ARR

  • Ignores the timings of returns
  • Total returns and lifespan are predictions, making ARR inaccurate
• PBP (Payback Period) plus ARR equals a good combination of investment appraisal techniques
• Units of measurement: PBP is in years/months, ARR is a percentage,
• Investment appraisal techniques are quantitative, but qualitative factors should also be considered for a balanced business decision