Investment Appraisal

• what is investment appraisal?

  Investment Appraisal is a technique used to evaluate planned investment by a business and measure its potential value to the business.

  There are several different IA methods used to compare projects that may be competing for a business’ investment capital.

  • Payback period

  • Average rate of return (ARR)

  • Discounted Cash Flow (DCF)
• what is payback period?


  The payback period is how quickly an investment is able to

  repay back the money invested into a project.

  This is important for several reasons:

  The quicker the money is paid back the sooner it can be reinvested into

  other projects.

  Many projects are financed through debt e.g. loans. The faster the

  repayment the sooner these debts can be repaid.

  It enables a simple comparison to be made between different

  investments to see which one repays the money the fastest.
• what is the formula for payback period?

  month of payback = income needed in period / contribution per month
• advantages of payback period

  • Easy to calculate and simple to use.

  • Helps with managing cash flow.

  • Considers timings of cash flows.

  • Effective to use when technology is changing at a fast rate, such as hi-tech projects, in order to recover the cost of investment as quickly as possible.
• disadvantages of payback period

  • Ignores what happens after the payback period.

  • May encourage a short-term attitude.

  • Ignores total profitability, the focus is just on the speed to which the initial outlay is repaid.
• Average Rate of Return (ARR)

  The ARR method considers the value of the average annual profit generated by an investment against the initial cost
• ARR


  • Presented as a %
  • Enables a comparison to be made between the investment and other uses for the money
  • Calculated as a percentage of the initial investment to allow an easy comparison between different financial options
  • Considers the profitability of the investment over its entire life time and does not stop once payback has been reached
• If you kept the cash in the bank instead of investing, you would receive a higher return but it would certainly be less risky
• What is the formula for ARR?

  ARR = Average Annual Return / Initial Outlay x 100
• Advantages of ARR?


  • Uses all the cash flows over life of the project.

  • Focuses on profitability.

  • Easy to make comparisons (compare % returns on different investments).

  • Allows comparison with costs of borrowing for investment.
• Disadvantages of ARR


  • Ignores timings of the cash flows.

  • Does not allow for effects of inflation on values of future cash flows
• what is discounted cash flow?

  The discounted cash flow method of investment appraisal considers the time value of money i.e., the realisation that the value of money changes over time
• what is net present value (NPV)?

  Net Cash Flow (NCF) is a measure of the total amount of cash flowing in and out of a business.

  For investment appraisal, NCF helps a firm to understand the financial gains from investing in a particular project.

  The higher the net cash flow the quicker a project will repay the

  initial investment.
• Advantages 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.

  • Discounts can be changed to accommodate changes in the economic and financial climate.

  • Allows for effect of risk on estimated future cash flows.
• disadvantages of NPV


  • Complex to calculate.

  • Discount factors could be incorrect which makes the NPV inaccurate.

  • Difficult to set discount factors far into the future, the longer into the future we go the less reliable the discount factor.

  • Interest Rate estimations over time period may be inaccurate
• Qualitative factors of investment appraisal

  Internal business considerations such as:

  • Does the investment match the strategy and objectives of the business?

  • Impact on staff. Can staff handle the changes brought about by the investment? Can staff be trained to use new technology? Will there be redundancies as a result of the investment?

  • Impact on existing products. Will managers concentrate on new products/investment to the detriment of existing output?
• External Economic Environment factors

  • The state of the economy
  • Action of competitors
  • Ethical considerations
  • Availability of funding
  • Availability of new technology
  • Confidence of managers
• The state of the economy

  Is the economy booming? Or is there a recession, which is likely to reduce demand, on the way?
• Action of competitors


  Are they investing in/improving their products?
• Ethical considerations


  Would the investment damage the environment?
• Availability of funding


  Is there sufficient funding available to invest in the project? Would the investment put the business at risk by reducing cash flow or increasing borrowing?
• Availability of new technology

  New technology is one of the main factors that encourage further investment
• Confidence of managers


  Optimistic managers are more likely to invest