3.7.8 investment appraisal

what is investment appraisal

process of assessing the attractiveness and viability of an investment project

purpose of investment appraisal

• to decide which project gives the best return of the money invested

• to compare different investment options

• to manage risk and uncertainty

• to support strategic planning

what are financial methods of investment appraisal 

1. payback period 

2. average rate of return

3. net present value

what is payback period

time it takes for the initial investment to be recovered from net cash flow

what is the formula for payback period

time before recovery + amount still to recover / cash flow in following year 

advantages of payback period

• simple and easy to understand 

• focuses on liquidity 

• useful when markets change quickly 

disadvantages of payback period

• ignores cash flows after payback

• ignores time value of money 

• doesn’t measure total profitability

what is average rate of return

• measures the average annual profit generated as a percentage of the initial investment

what is the formula for average rate of return

average annual profit / initial investment X100

advantages of average rate of return

• easy to compare with target return rates 

• considers total returns over the project’s life 

disadvantages of average rate of return

• ignores timing of cash flows

• doesn’t consider the time value of money

• can be influences by accounting estimates 

what is net present value 

total value today of a project’s future cash inflows discounted to reflect the time value of money 

advantages of net present value 

• considered all cash flows

• accounts for time value of money

• links directly to the objective of maximising shareholder wealth 

disadvantages of net present value 

• more complex to calculate

• depends on accurate discount rate

• harder to explain to non-financial managers

what are the factors influencing investment decisions 

1. investment criteria

2. non-financial factors

3. risk and uncertainty

what is investment criteria

• targets or tules businesses use to judge investments 

what is risk and uncertainty

• future conditions being unpredictable 

how to manage risk and uncertainty

• senario planning

• sensitive analysis 

• diversification of projects

• use of real options 

strategic implications

• expansion into new markets

• investment in new technology 

• acquisitions or diversification

functional implications

• operations: resource allocation

• finance: budgeting and funding 

• HR: workforce planning

• Marketing: forecasting and pricing strategies 

strengths of investment appraisal

• improves decision making with objective financial data 

• allows comparison of alternatives

• identifies timeframes and payback expectations

limitations of investment appraisal

• relied on forecasts - may be innacurate

• ignores qualitative or ethical factors if used alone

• sensitive to interest rate or inflation changes 

• doesn’t eliminate uncertainty, only reduces it