Investment Appraisal

What is investment appraisal?

A way in which business decides whether or not an investment project is worthwhile

What are the main methods of investment appraisal?

• Payback

• ARR

• NPV

Method 1: payback

How long does it take an investment to payback its initial outlay

Useful for businesses with cash flow problems

The longer it takes to payback, the higher the risk because there is an increased likelihood that something will change the projected cash flows

Payback

Sum invested/net cash per time period

• Payback limitations

• Does not measure profitability

• Ignores cash flows after payback period

Method 2 ARR

Annual average return/Initial outlay x100

Advantages of arr

Uses au cash flows over the life of a project

Focuses on profitability

Uses % so easy to compare returns on different investments and help to make a decision

• Disadvantages of ARR

Not as accurate as payback

Ignores timings of cash flows

Ignores the opportunity cost of the money invested

Net Present Value NPV

Multiply net cash flow by the discount factor

The net inflows are added up and then the cost of the initial investment is deducted

Investment with the highest NPV should be accepted

Advantages of NPV

Takes the opportunity cost of the money into account

Consider different scenarios

Disadvantages of NPV

Complex to calculate and communicate

Only comparable with projects where the amount is invested is the same