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Investment Appraisal

Investment Appraisal

Investment appraisal refers to the process of appraising or working out, whether an investment is likely to meet the business’ project objectives.

Use of investment appraisals

  • Investment appraisal allows a business to work out whether an investment is profitable enough, or whether it pays back quickly enough.

  • Investment appraisal also allows a business to compare one project with another project and decide which project is the most suitable for the business’ needs.

Risk of investment

  • Investments carry risk for businesses as all investments require a financial commitment.

  • Investments involve taking risks in the hope of a possible reward, or profit.

  • Investment appraisal allows businesses to decide whether any potential return is worth the risk associated with an investment.

Information for investment appraisals

  • Businesses need to gather as much information as possible about any investments they are considering.

  • Investment appraisal includes three techniques which provide a business with different information about any potential investment:

    • Net Present Value.

    • Average Rate of Return.

    • Payback.

Net Present Value

  • Net Present Value is expressed using a real value in pounds and pence.

  • A negative NPV suggests that a project will not make a business any money whereas a positive NPV suggests that a project will produce a return for the business.

Average Rate of Return

  • Average Rate of Return is expressed as a percentage and is calculated using:

    • (Average net return ÷ investment) × 100

  • The higher the ARR percentage, the higher the project return in comparison to the original investment.

  • The ARR can be used to compare the project with other projects, including investing the money in a bank account and accruing interest.

Payback

  • Payback is expressed as a period of time. It is the amount of time for cash flow to be equal to the initial cost of a project.

  • The shorter the payback, the quicker the business recovers its original investment.

  • The payback period can be used to compare the project with other projects and businesses with liquidity concerns may choose a project with the quickest payback.