# 3.8 Investment appraisal

## 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.