Investment Appraisal Vocabulary

A set of vocabulary flashcards defining core terms, formulas, and decision criteria for investment appraisal techniques including Payback Period, ARR, NPV, and IRR.

Capital Investment Decisions

Decisions that involve current outlays in return for a stream of benefits in future years, committing a substantial proportion of a firm's resources to actions that are likely to be irreversible.

Basic Information Required for Investment Appraisal

The key input information needed to appraise a project: cost of investment project, estimated life of the project, estimated net cash receipts from the project, and cost of capital.

Payback Period

The length of time required for a stream of cash proceeds from an investment to recover the original cash outlay required by the investment.

Accounting Rate of Return (ARR)

An investment appraisal technique using profits rather than cash flows, calculated as $\left(\frac{\text{average profit}}{\text{average investment}}\right) \times 100$.

Average Investment Formula

The formula used to determine the denominator in the ARR equation: $\text{Average Investment} = \frac{\text{Cost of Investment}}{2}$.

Average Accounting Profits

The difference between additional revenues and costs that follow from an investment project.

Time Value of Money

The principle recognizing that $\$1$ received now is worth more than $\$1$ received in the future.

Net Present Value (NPV)

An investment appraisal method that allows for the time value of money by discounting future net cash flows to present day values using the cost of capital.

NPV Decision Criteria

A decision rule where a positive NPV indicates a project is worthy of further consideration, while a negative NPV indicates the project should not be considered.

Internal Rate of Return (IRR)

The discounting rate which equates the discounted net receipts from a project to its cost, resulting in a net present value (NPV) of zero.

IRR Formula

The formula used to calculate IRR: $IRR = A + \left[\left(\frac{a}{a + b}\right) \times (B - A)\right]$, where $A$ is the lower discount rate giving positive NPV $a$, and $B$ is the higher discount rate giving negative NPV $b$.

IRR Decision Criteria

A decision rule where a project is accepted if $IRR > \text{Cost of Capital}$ and rejected if $IRR < \text{Cost of Capital}$.