Explains the three types of investment appraisal - payback, average rate of return (ARR) and net present value (NPV) - including how to calculate them and the advantages and disadvantages of each method. Also includes qualitative factors to consider when making investment decisions.
Theme 3 Topic 7
Investment Appraisal
Investment Appraisal
Investment Appraisal – a scientific approach to investment decision making, which investigates the expected
financial consequence of an investment, in order to assist the business in its choices
Before making a decision, a business must assess whether the investment will be financially viable, by carrying
out quantitative calculations:
Payback
Average Rate of Return (ARR)
Net Present Value (NPV)
In order to do the calculations, the business needs the following financial information:
The initial cost of the investment
The estimated net return (Revenue – Cost) per year
The estimated lifetime of the investment
The business must also consider qualitative factors.
Payback
Payback – the length of time it takes for an investment to pay for itself – a business will want as short a
payback period as possible
Payback = Cumulative Return of Payback Year x 52 OR 12 (52 for weeks, 12 for months)
Net Return of Following Year
Advantages Disadvantages
Useful when technology changes rapidly Cash earned after the payback period is
and investment cost needs recovering ignored
quickly Time value of money is ignored
Simple to use Focusing on payback results in short-
Focuses on early cash flow so good for termism i.e. failing to look ahead at the
firms with liquidity worries long term consequences
Average Rate of Return Per Year
Average Rate of Return Per Year – the average return of the investment, expressed as a percentage of the
initial cost of the investment – a business will want as high a rate of ARR as possible (it should be higher than
bank interest rates)
ARR = Average Annual Profit x 100
Initial Cost of Investment
Advantages Disadvantages
Shows clearly the profitability of an Time value of money is ignored
investment Harder and more time consuming to
Includes the returns from all years calculate than payback
Can easily be compared with bank interest
in a savings account
Net Present Value (Discounted Cash Flow)
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