Theme 3

Investment Appraisal

Attempts to determine the value of capital expenditure projects.

Planning process

This is used in IA to determine whether the long term investments will give the best return

Simple Payback

The payback period is a calculation of the amount of time it is expected an investment will take to pay for itself 

Simple payback formula

Payback period = Initial outlay / net cash flow per period = years or months 

Initial payback 

To find out how many months in initial payback after the last full year 

(Difference / base)*12  

Advantages of Initial payback method

Simple method to calculate and understand 

Is useful when business cashflow management is vital 

can identify the point at which an investment is paid back and contributing positively to cash flow 

useful where new technology is introduced regularly

Disadvantages of initial payback method

no insight into the profitability of investments 

Payback only considers the total length of time to recover an investment 

Neither the timing nor the future value of cash inflows is considered 

Investments may be dismissed as they take longer to pay back than alternatives 

Average rate of return 

compares the average profit per year generated by an investment with the value of the initial outlay

ARR formula

ARR = (average annual return / initial outlay) *100 

expressed as a percentage