Investment Appraisal Notes

Investment Appraisal Formulas (IB Format)

Method 1: Payback Period (PBP)

  • Formula for Constant Cash Flows:
    PBP = Initial Investment / Annual Cash Flow

  • Cumulative Cash Flow Calculation:

    • Add cash inflows year by year until total cash flow equals or exceeds initial investment.

  • Advantages:

    • Simple and easy to understand.

    • Provides a quick measure of liquidity risk.

  • Disadvantages:

    • Ignores the time value of money.

    • Does not take into account cash flows beyond the payback period.

Method 2: Average Rate of Return (ARR)

  • Formula: ARR = (Average Annual Profit / Initial Investment) x 100

    • Includes any scrap value at the end of the investment period.

  • Advantages:

    • Simple calculation based on accounting profits.

    • Useful for comparing different investments.

  • Disadvantages:

    • Does not consider time value of money.

    • Can be misleading if profits fluctuate significantly over time.

Method 3: Net Present Value (NPV) (HL Only)

  • Formula:
    NPV = Sum of Present Values - Cost of Investment

  • Present Value Calculation for Future Cash Flows:
    PV = Cash Flow / (1 + r)^n

    • Where:

      • PV = Present Value

      • r = Discount rate (expressed as a decimal)

      • n = Number of years until cash flow occurs

  • Advantages:

    • Considers the time value of money.

    • Provides a direct measure of profitability.

  • Disadvantages:

    • Requires accurate estimation of future cash flows.

    • Discount rate can significantly affect results.

Additional Note

  • It is essential to express your results correctly for examination:

    • PBP in time (years and months)

    • ARR as a percentage

    • NPV as a monetary value.

  • Key Consideration in Decision Making:

    • Use these methods in conjunction with qualitative factors and strategic considerations for comprehensive investment analysis.