Unit 3.8: Investment Appraisal

Investment

The purchase of an asset with the potential to yield future financial benefits

Investment Appraisal

Refers to the quantitative techniques used to calculate the financial cost AND benefits of an investment decision - Assess the risks involved 

3 types of investment appraisals

1. Payback Period (PBP)

2. Average Rate of Return (ARR):

3. Net Present Value - HL

Payback Period (PBP)

Amount of time needed for an investment project to earn enough profits to repay the initial cost of investment

Application of PBP

• Investment projects are normally only considered if that have a short PBP

• In most cases the business will not invest in equipment that will become obsolete before the PBP period 

Advantages of PBP

1. Simplest/ quickest method of investment appraisal

2. Useful for firms with cash flow (liquidity) problems 

3. Whether they break-even and even make profit on the asset before it must be replaced

4. PBP of different investments can be easily calculated to determine the best option 

5. Helps managers assess projects that will yield quick returns for shareholders

Disadvantages of PBP

1. Monthly addition is unlikely to stay constant due to demand and seasonal fluctuations

2. Focuses on how long it will take to break-even rather than the profit made

3. Encourages to only consider short term benefits - ignoring long term gains

4. Not the best for some businesses 

5. Calculations are prone to error as its hard to predict future cash flow

Average Rate of Return (ARR)

Calculates the average profit on an investment project expressed as a percentage of the amount invested

1. Calculate cumulative cash flow of the years it was used

2. Minus the cost of the investment 

3. AVG Annual Profit = (Cumulative-cost of investment)/ years it was used

4. Avg Annual profit / cost of the investment = ARR

Application of ARR

• Managers can compre the return on different investments projects 

• Can be compared with base interest rates in the economy to asses the rewards for the risks involved 

  • Eg, ARR =7%, but the interest rate on savings is 3% than the real rate of return is 4%

  • For small business this might not be enough of an incentive to do especially with the risks of it

Advantages of ARR

• Enables easy comparisons (in percentage terms) of the estimated returns on different investment projects.

Disadvantages of ARR

• Ignores the timings of the net cash flows and hence is prone to forecasting errors when considering seasonal factors

• The project's useful life span (which might be a pure guess) is needed before any meaningful calculations can be made

• Errors are more likely the longer the time period under consideration