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:
1. Multiply discount factors by the cash flows. Cash flows in year 0 are never discounted as they are today’s values already.
2. Add the discounted cash flows.
3. 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.