3.8 Investment appraisal

What is investment appraisal?

  • Investment appraisal: evaluating the profitability or desirability of an investment project.

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  • 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

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  • Methods of quantitative investment appraisal:   * Payback period   * Average rate of return   * Net present value using discounted cash flows

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  • 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.

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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.

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  • Net present value (NPV): today’s value of the estimated cash flows resulting from an investment.   * CalculatingNPVCalculating 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=Totaldiscountedcashflows−OriginalinvestmentNPV = 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.

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