3.8 Investment appraisal

**Investment appraisal**: evaluating the profitability or desirability of an investment project.**Quantitative investment appraisal**requires:Initial capital cost of the investment

Estimated life expectancy

Residual value of the investment

Forecasted net returns or net cash flows from the project

**Methods of quantitative investment appraisal**:Payback period

Average rate of return

Net present value using discounted cash flows

**Quantitative techniques of investment appraisal**Payback method

**Payback period**: length of time it takes for the net cash inflows to pay back the original capital cost of the investment

**Average rate of return (ARR)**measures the annual profitability of an investment as a percentage of the initial investment.

**Discounting future cash flows****Present value of a future sum of money**depends on two factors:The higher the interest rate, the less value future cash has in today’s money.

The longer into the future cash is received, the less value it has today.

**Net present value (NPV)**: today’s value of the estimated cash flows resulting from an investment.**Calculating NPV**:Multiply discount factors by the cash flows. Cash flows in year 0 are never discounted as they are today’s values already.

Add the discounted cash flows.

Subtract the capital cost to give the NPV.

Example:

**NPV = Total discounted cash flows - Original investment**→ $11,940 - $10,000 =

**$1,940**→ The project earns $1,940 in today’s money values. So, if the finance needed can be borrowed at an interest rate of 8% or less, the investment will be profitable.

**Investment appraisal**: evaluating the profitability or desirability of an investment project.**Quantitative investment appraisal**requires:Initial capital cost of the investment

Estimated life expectancy

Residual value of the investment

Forecasted net returns or net cash flows from the project

**Methods of quantitative investment appraisal**:Payback period

Average rate of return

Net present value using discounted cash flows

**Quantitative techniques of investment appraisal**Payback method

**Payback period**: length of time it takes for the net cash inflows to pay back the original capital cost of the investment

**Average rate of return (ARR)**measures the annual profitability of an investment as a percentage of the initial investment.

**Discounting future cash flows****Present value of a future sum of money**depends on two factors:The higher the interest rate, the less value future cash has in today’s money.

The longer into the future cash is received, the less value it has today.

**Net present value (NPV)**: today’s value of the estimated cash flows resulting from an investment.**Calculating NPV**:Multiply discount factors by the cash flows. Cash flows in year 0 are never discounted as they are today’s values already.

Add the discounted cash flows.

Subtract the capital cost to give the NPV.

Example:

**NPV = Total discounted cash flows - Original investment**→ $11,940 - $10,000 =

**$1,940**→ The project earns $1,940 in today’s money values. So, if the finance needed can be borrowed at an interest rate of 8% or less, the investment will be profitable.