3.8 Investment Appraisal

Average rate of return (ARR)

Calculates the average annual profit of an investment project, expressed as a percentage of the initial amount of money invested.

Cumulative net cash flow

Sum of an investment project’s net cash flows for a particular year plus the net cash flows of all previous years.

Discount factor

Number used to reduce the value of a sum of money received in the future in order to determine its present (current value)

Discounted cash flow

Uses a discount factor (inverse of compound interest) to reduce the value of money received in future years as money loses its value over time.

Investment

Refers to capital expenditure or the purchase of assets with the potential to yield future financial benefits.

Investment appraisal

Financial decision-making tool that helps managers to determine whether certain investment projects should be undertaken based mainly on quantitative techniques.

Net present value (NPV)

Calculates the total discounted net cash flow minus the initial cost of the investment. A positive value means that the project is viable on financial grounds.

Payback period (PBP)

An investment appraisal technique that calculates the length of time it takes to earn back the initial expenditure on an investment project.

Principal (capital outlay)

Original amount spent on an investment project.

Qualitative investment appraisal

Judging whether an investment project is worthwhile through non-numerical techniques such as determining whether the investment is consistent with the corporate culture.

Quantitative investment appraisal

Judging whether an investment project is worthwhile based on numerical (financial) interpretations, namely the PBP, ARR, and NPV methods.