Investment Appraisal

3.8

investment

the business expenditure on non current assets with the potential to generate future financial benefits

investment appraisal

a quantitative decision-making tool used to assess whether the capital expenditure of a firm is justifiable in terms of whether it will be financially worthwhile

payback period (PBP)

measures the estimated time it will take for an investment project to earn a profit to recover the initial cost of the investment

average rate of return (ARR)

measures the predicted annual profit generated from an investment project, expressed as a percentage of the initial investment cost

pros of PBP

• simple and quick calculation

• easy for managers to interpret and understand

• the depreciation can be easily included in the computation

• helps managers to quickly choose investment projects with shorter PBP

• therefore useful in rapidly changing industries (time until the next investment)

• less prone to inaccuracies of long term forecasting due to short term measure

cons of PBP

• ignores the time value of cash, despite the future value of cash being lower

• not suitale for long-term projects (those with LONG PBP)

• focuses on time rather than profitability, which could be unrealistic for some

• it does not consider the useful life of the non-current asset after PBP

pros of ARR

• simple to understand and straightforward to calculate

• focuses on profitability rather than time, unlike PBP

• can evaluate financial performance

• useful to compare the attractiveness of a range of different projects as ARR is expressed in percentage

cons of ARR

• ignores the time value of cash, unlike the NPV method

• focuses on profits rather than cash flow in order to break even quickly and to generate cash to invest in other projects, unlike PBP

• the figures are prediction only, tend to be less accurate the longer the investment project is

net present value (NPV)

a investment appraisal that calculates the real value of an investment project by discounting the value of future cash flows

discount rate

a number used to reduce the value of a sum of money received in the future in order to determine its present value (opposite of a compound interest rate)

pros of NPV

• considers future net cash flows expressed in today’s value, making the data more realistic

• more accurate than ARR as the NPV method discounts the future depreciation of cash/money

cons of NPV

• can be tedious to calculate, especially as so many variables alter the final net cash flow figures

• can be difficult or subjective to decide on an accurate discount rate

• difficult to accurately forecast net cash flows in the distant future