Chapter 9 - Investment appraisal techniques

What are the 4 investment appraisal techniques?

• Payback Period – Measures how long it takes to recover the initial investment.

• ARR (Accounting Rate of Return) – Measures the average annual profit as a percentage of the investment.

• NPV (Net Present Value) – Measures the value added by a project by comparing discounted cash inflows and outflows.

• IRR (Internal Rate of Return) – The rate of return a project generates; the discount rate where NPV = 0.

How do you calculate the payback period?

Keep adding cash inflows until the initial investment is recovered.
For part-years: Remaining amount ÷ Next year's cash flow × 12 months.

Advantages of payback period?

• Quick and easy to calculate.

• Favours faster payback, reducing risk.

Disadvantages of payback period?

• Ignores cash flows after payback.

• Ignores the time value of money.

How do you calculate ARR?

ARR = Average annual profit ÷ Investment × 100

Advantages of ARR?

• Simple to calculate.

• Looks at the whole project's life.

Disadvantages of ARR?

• Uses profit, not cash flow.

• Ignores the time value of money.

What is the time value of money?

Money today is worth more than the same amount in the future.

What is discounting?

Converting future cash flows into today's value.

What is the discount factor?

The factor used to convert future cash flows into present values.

How do you calculate NPV?

Total discounted inflows − Initial investment.

What does a positive NPV mean?

The project earns more than the cost of capital, so accept it.

What is an annuity?

The same cash flow received every year.

What is a perpetuity?

The same cash flow received forever.

Advantages of NPV?

• Considers time value of money.

• Includes all relevant cash flows.

Disadvantages of NPV?

• Requires a cost of capital estimate.

• Assumes annual cash flows.

What is IRR?

The discount rate where NPV = 0.
Accept if IRR is greater than the cost of capital.

How do you calculate IRR?

Use interpolation between a positive NPV and a negative NPV.

Advantages of IRR?

• Easy to understand as a %.

• No need to know the cost of capital first.

Disadvantages of IRR?

• Can give multiple answers.

• Not reliable for comparing mutually exclusive projects.

If NPV and IRR give different answers, which is better?

NPV, because it maximises shareholder wealth.

What are the 4 environmental cost categories?

• Prevention costs – stop damage happening.

• Appraisal costs – monitor and check compliance.

• Internal failure costs – waste before release.

• External failure costs – damage after release.

Why include environmental costs in investment appraisal?

They affect cash flows, reduce risk, and help meet ESG and legal requirements.