3.08 Investment Appraisal

Investment

The purchase of an asset with the potential to yield future financial benefits – machinery or buildings.

Investment appraisal

The quantitative techniques used to calculate the financial costs and benefits of an investment decision.

Payback Period (PBP) (Not on formula booklet)

The amount of time needed for an investment project to earn enough profit to repay the initial cost of the investment. – The shorter the payback period, the better (context)

Pros and Cons of Payback Period 

+Simple and quick

+Useful for identifying cash flow problems
-Focuses on time rather than potential profits
-Might not be suitable for some firms (airlines manufacturer) that takes years to break even.

Average Rate of Return (ARR)

The average profit on an investment project is a percentage of the amount invested.

Expressed as a percentage

Pros and Cons of ARR

+Easy comparisons of projects
-Product useful lifespan is needed for calculation, which is oftentimes difficult 

-Ignores the timing of cash inflows and outflows (money worth changes)

Net Present Value

Discounting

A discount factor is used to convert the future net cash flow to its present value today. Given that receiving money today is worth more than it is in the future, the discount factor can represent inflation and/or interest rates.