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.

  • 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.

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