3.8 Investment Appraisal

Investment Appraisal

Refers to a series of quantitative techniques designed to assist businesses in judging the desirability of investing in particular projects

Payback Period equation for below one year

1. subtract each net cash flow from each year from the initial capital cost

2. Use equation attached

Advantages of Payback Period

• Quick and easy to calculate

  • Effect: Business can make decisions quicker, higher productivity

Disadvantages of Payback Period

• Only assesses the investment through how fast the company receives its investment back

  • Effect: Investment may not contribute to goals such as improving brand image/awareness/loyalty. Could also encourage short-term thinking (depends on link)

• Does not consider the profits the investment will ultimately make

  • Effect: Ignoring the opportunity for better cash flows in the future is an opportunity cost.

• Does not take into account the timing of any income received

  • Effect (?): Can not judge which investment yields higher profits in the beginning

Average rate of Return Calculation

See attached file

Advantages of Average Rate of Return (ARR)

• Considers the level of profits earned from an investment as it uses all cash flows

  • Effect: Ensures the business chooses the most profitable investment

• Easy comparison with investments such as loans/other investments from banks

Disadvantages of Average Rate of Return (ARR)

• Does not take into account the timing of any income received

  • Effect: could negatively impact the liquidity position of the business