Unit 3 – Finance and Accounts
3.8 – Investment Appraisal
Investment appraisal is the process businesses use to evaluate the attractiveness and potential returns of investment projects. It helps managers decide where to allocate funds for the best financial benefit.
- Ensures sound decision-making on capital spending
- Reduces risk of expensive mistakes
- Compares different projects or investment options
Payback Period
Payback period is the time it takes for an investment to generate enough cash flows to recover the initial outlay.
Formula:
\[ \text{Payback Period} = \frac{\text{Amount invested (Initial Outlay)}}{\text{Annual Net Cash Inflow}} \]
Formula:
\[ \text{Payback Period} = \frac{\text{Amount invested (Initial Outlay)}}{\text{Annual Net Cash Inflow}} \]
- Simple and easy to understand
- Ignores cash flows after payback and the time value of money
- Best for projects where early recovery is critical
Average Rate of Return (ARR)
Average Rate of Return measures the average annual profit as a percentage of the initial investment.
Formula:
\[ \text{ARR (\%)} = \left(\frac{\text{Average Annual Profit}}{\text{Initial Investment}}\right) \times 100 \]
\[ \text{ARR} = \left(\frac{10,000}{100,000}\right) \times 100 = 10\% \]
Formula:
\[ \text{ARR (\%)} = \left(\frac{\text{Average Annual Profit}}{\text{Initial Investment}}\right) \times 100 \]
- Takes into account all inflows over the project’s life
- Easy to compare multiple projects
- Ignores timing of profits (time value of money)
\[ \text{ARR} = \left(\frac{10,000}{100,000}\right) \times 100 = 10\% \]
Net Present Value (NPV)
Net Present Value calculates the total value of future cash flows (discounted back to present value) minus the initial investment.
Formula:
\[ \text{NPV} = \sum_{t=1}^{n} \frac{\text{Net Cash Flow}_t}{(1+r)^t} - \text{Initial Investment} \] Where \( r \) = discount rate, \( t \) = time period
\[ \text{NPV} = \left(\frac{5,000}{1.1^1} + \frac{6,000}{1.1^2}\right) - 10,000 \approx (4,545.45 + 4,958.68) - 10,000 = -495.87 \] Negative NPV = Do not invest.
Formula:
\[ \text{NPV} = \sum_{t=1}^{n} \frac{\text{Net Cash Flow}_t}{(1+r)^t} - \text{Initial Investment} \] Where \( r \) = discount rate, \( t \) = time period
- Considers the time value of money—more realistic for long-term projects
- Positive NPV = invest; Negative NPV = do not invest
- May be more complex (requires choosing “correct” discount rate)
\[ \text{NPV} = \left(\frac{5,000}{1.1^1} + \frac{6,000}{1.1^2}\right) - 10,000 \approx (4,545.45 + 4,958.68) - 10,000 = -495.87 \] Negative NPV = Do not invest.
Comparison Table: Appraisal Methods
| Method | Considers Timing | Considers All Cash Flows | Simple? | Main Use |
|---|---|---|---|---|
| Payback Period | No | No | Yes | Quick check, early recovery is vital |
| ARR | No | Yes (average) | Yes | Comparing average yearly returns |
| NPV | Yes | Yes | No | Most accurate for investment value |
Key Takeaways
- Investment appraisal helps businesses choose the best use of capital and avoid risky projects.
- Payback period is quick but ignores time value & later profits; ARR gives an average percentage return; NPV recognizes the real value of money over time.
- Use all methods together for the most informed decision—no one method is best for every situation.