3.8 - Investment appraisal

What does investment appraisal mean?

To evaluate the advantages and disadvantages of an investment, in terms of quantitative and qualitative factors

What are the three quantitative methods of investment appraisal?

1. Payback period

2. Average rate of return

3. Net present value

What is the payback period?

The time it takes for the investment to have generated enough revenue to make a profit and repay the cost of the initial investment

What are methods to calculate the payback period?

The formula: Capital cost / contribution per month

The cumulative cash flow method:

Add up the net cash flow for each year

Find out between which two years the profit was made (e.g., between year 3 and year 4)

Calculate the difference between the initial investment cost and the revenue made in year 3

Divide the net cash flow of year 3 by 12 to find the month

Divide the answer from step 3 by the answer from step 4

What are advantages and disadvantages of the payback period method?

Firms can see whether they will break even on the purchase before it needs to be replaced

It can be used to compare against other investment projects, how quickly they will get their money back

The formula method is unrealistic, as the contribution per month is unlikely to be the same

What is the average rate of return?

It calculates the profit on an investment project as a percentage of the amount invested

What is the ARR formula?

((Total returns - capital cost) / years of use) / capital cost x100

What are advantages and disadvantages of the ARR method?

It shows profitability of an investment

The calculations are based on the projects lifespan which may be a pure guess and unrealistic

What is the net present value?

It is the present value of an investment, once depreciation has been deducted

What is the net present value calculation method?

The formula Sum of present values - original cost

The present value is net cash flow for each year x discount factor

What are some qualitative factors of investment appraisal?

The investments effect on brand image

The investments advantage in term of competition

Sustainability or ethical issues