What is 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.

Higher level (discounting and net present value)

• 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.