Investment Appraisal

Investment Appraisal / Capital

the process of evaluating the potential profitability and viability of an investment projec

The payback period (PBP)

the time it takes for the initial amount of money invested to be repaid using the gains from the original investment. PBP helps to assess whether a project is financially worthwhile and to justify the capital expenditure needed for the investment.

Break-even

reach a point in a business venture when the profits are equal to the costs.

Formula for payback period (PBP) (1)

total investment cost / (net cash flow / 12)

Formula for payback period (PBP) (2)

• Find cumulative net cash flow

• Identify the year that debt is settled

• Determine net cash flow that year and divide by 12

• Identify debt that must be settled the previous year and divide by the value

Meaning of Payback Period

A shorter payback period is preferred to a longer one, as it minimises the risks of an investment project and earns profit for the business at an earlier date.

ADV of payback period

• Fastest, easiest way to calculate investment appraisal

• Easy to understand

• aids decision making

DIS of payback period

• Usually not suitable for determining long-term projects because long PBP is risky

• Does nor reveal profitability of an investment

Average rate of return

the average annual profit of an investmenet expressed as a percentage of the initial amount of money. This will help managers to decide whether to accept or reject the proposed investment project.

Formula of ARR (1)

[(total net cash flow - investment cost) / years used / investment cost ] x 100

Formula of ARR (2)

Average annual profit / initial investment cost x 100

adv of ARR

• straightforward to calculate, easy for people to understand

• Allow for judgement of financial performance

dis of ARR

• Ignores the timings of future net cash flows, so money may be worth less

• Focuses on profits, not cash flow (neg cash flow means no profits?!?!)

time value money

the financial principle that money now has more value than in the future

Net present value

method is used to work out the present value of the return on an investment

Discount rate

a figure used to reduce the future value of money. It is used to establish the present value of cash that is yet to be received by the business.

Present value fomrula

Present value = cash flow x discount factor

Net present value meaning

A positive NPV indicates that the projected earnings generated by a project or investment—discounted for their present value—exceed the anticipated costs, also in today’s dollars. It is assumed that an investment with a positive NPV will be profitable.

An investment with a negative NPV will result in a net loss.

adv of net present value

• It is more realistic and accurate method that takes a long-term view into account 

• The method accounts for the future movements of cash flows from an investment project or decision 

• By showing these future cash flows expressed in today’s monetary value, it helps managers with informed decision

dis of net present value

• Ignores timing of cash inflows and prone to forecasting errors when considering seasonal factors 

• Calculations are based on a project;is useful lifespan which might be a pure guess