3.8 Investment Appraisal

Investment Appraisal

The quantitative techniques used in evaluating the viability or attractiveness of an investment proposal.

The Three Methods of Investment Appraisal

1) Payback Periods

2) Average Rate of Return

3) Net Present Value

Payback Period

The length of time required for an investment project to pay back its initial cost outlay. Through multiplying by 12 months, it is possible to determine on which month it would be paid back.

Advantages of Payback Period

• It is simple and fast way to calculate

• It is useful method in rapidly changing industries to determine an estimate time in which initial investment is recovered.

• It helps with cash flow problems It is a short-term measure of quick return on investment.

• Business Managers can easily understand and use the results obtained

Disadvantages of Payback Period

• It does not consider the cash earned after the payback period, which could influence major investment decisions.

• It ignores the overall profitability of an investment project by focusing only how fast it will payback.

• The annual cash flows could be affected by unexpected external changes in demand, negatively affecting the payback period.

Average Rate of Return (ARR)

Measures the annual net return on an investment as a percentage of its capital cost.

Advantages of Average Rate of Return

• It shows the profitability of an investment project over a given period of time.

• Unlike the payback period, it makes use of all the cash flows in a business.

• It allows for easy comparisons with other competing projects for better allocation of investment funds.

• A business can use its own criterion rate and check this with the ARR for a project to assess the viability of the venture

Disadvantages of Average Rate of Return

• Since it considers a longer time period or useful life of the project, there are likely to be forecasting errors. Reducing the accuracy of the results.

• It does not consider the timing of cash inflows. Two project might have the same ARR, but one could pay back more quickly compared to the other due to faster cash inflows.

• The effects on the time value of money are not considered.