Investment Appraisals

Definition

Investment appraisals are quantitative techniques that a manager will use to see if a project is worth investing in.

Notes

• They are based on cash flow which is the cash coming into and going out of a business.
• The further ahead a business predicts into the future, the less accurate it will be.

Payback - how long will it take to recover the investment?

This method identifies how long it will take the project to repay the initial investment cost.

Payback = income required to make cumulative +   

              net after cumulative + / 12

(inc req to make cumu +) / (net after cumu + / 12) 

Then add on the figure to the years

Notes

• It is not a measure of profitability.
• It is an especially important method for businesses that have poor liquidity because they do not have the financial resources to have their money tied up in long payback projects. 

Advantages

• Easy to calculate
• Focuses on the short term
• Takes the timing of cash flow into account

Disadvantages

• Not a measure of profitability 
• Ignores what happens after the payback period
• May encourage short-term attitude

Average Rate of Return (ARR) - What will I get from the project?

This methods allows the manager to calculate the average annual return percentage of the initial investment figure that a project will make.

ARR = Total net profit / number of years X 100

            initial cost

[(Total net profit / No. years) / initial cost] X 100

Notes

• It can be compared to other projects and the interest rate
• Average = Yearly
• Rate = Percentage %
• Return = Profit

Advantages

• Uses all cash flows over the life of the project
• Focuses on profitability
• Easy to compare different investments

Disadvantages

• Will not be as accurae as payback as later years are included in answer
• Ignores the timing of cashflows
• Ignores the opportunity cost of the money invested

Net Present Value - Will the project add value?

This method calculates the present value of all money coming into the business in the future.

NPV = Net cash flow X discount factor

Notes

• If the present value of the money spent is gretaer than the money you will get back in the future then it is better to put it into savings
• It allows you to compare different projects and uses a discount factor based on an assumed interest rate

Advantages

• Takes the opportunity cost into account
• Different scenarios can be considered

Disadvantages

• It can be complex to calculate
• Only projects with the same initial investment can be compared

Investment appraisals allow you to...

• Make investment decisions against an uncertain future 
• Balance risk and reward
• Analyse validity and accuracy of data
• Base decisions on quantitative data as well qualitative