Investment Appraisal
What is Investment?
Investment refers to the purchase of capital goods or any other use of
retained profits that is likely to earn a return in the future.
Investment is not the same as saving money in a bank or buying shares to try to earn
dividends.
Investment is the purchase of productive capacity. For example, buying equipment or a new
factory to increase capacity, meaning to increase the amount that can be produced. This will
lead to consumer demand being met and sales revenue being generated.
One of the main reasons why businesses invest is because they have to. Most firms use plant,
machinery, equipment, vehicles, tools and other capital goods. Considerable investment is
necessary when a business is being set up, however even when a business is established
investment will continue. Eventually capital goods will have to be replaced.
Further investment is made to help achieve the objectives of the business. Some examples are:
 Marketing, if the business wants to increase its market share
 Research and development (R&D)
 New technology, to minimise costs or improve quality
 New capacity, if the business wishes to diversity into new products or locations
 Acquisition of other businesses in order to expand or to buy out a rival firm
Investment Appraisal
This is the process of evaluating the profitability or desirability of an investment project.
It is a means of assessing whether or not the project is worthwhile. Investment appraisal
assesses the cost of the investment against the income streams it will generate.
Every investment decision has an opportunity cost. It is essential that firms evaluate
investment options. The consequences of poor investment could include:
 Cash flow/liquidity problems that could in the worst scenario lead to insolvency
 Reduced profitability
 Loss of shareholder confidence leading to a devaluation of
shares
 Under-utilisation of a new resource
 Reduced productivity/efficiency
 Loss of competitive advantage
 Damage to brand caused by negative publicity
 Lack of consumer and employee trust and loyalty
Investment appraisal requires the following quantitative information:
 Initial capital costs of the investment
 Estimated life expectancy of the asset
 The expected residual value of the asset (additional return from the sale of the asset at the
end of its useful life)
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
Forecasted net returns or net cash flows from the project (expected returns less running
costs)
Non-financial factors affecting investment
In addition to applying an Investment Appraisal formula to assess an investment option,
management should consider other issues, such as:
 Corporate objectives ~ does the investment meet corporate objectives of the business? A
long-term profit goal may allow investments with long payback periods, but if the
business is facing a cash flow crisis they may prefer shorter payback period
 Capacity for risk taking ~ is the benefit worth the risk?
 Operations ~ current production capacity? Will quality standard be maintained? Links and
relationships with suppliers?
 State of the economy ~ the current and forecast state of the economy will have a
significant effect on investment decisions
 The extent to which future cash flows can be measured accurately
 The need to factor in the effects of inflation
Methods of Investment Appraisal
1
2
3
Payback method
Average/accounting rate of return
Net present value
PAYBACK PERIOD
Definition
Advantages
Disadvantages
Formula:
Payback =
Example
Calculation
Result
The length of time it takes for net cash inflows to repay the original
capital costs of the investment
A quick and easy calculation
Focus is on cash which is normally scarce
Emphasis is on the speed of return
Makes assumptions about interest rates
Days/weeks/months x initial investment
Total cash received
A new machine will cost $600,000 and will take three years (36
months) to repay. It is estimated that the annual income stream from
the investment will be $255,000 p.a. ($765,000 over the three years)
36 x 600,000 = 21,600,000
765,000
28.23 months
AVERAGE/ACCOUNTING RATE OF RETURN
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Definition
Advantages
Disadvantages
Formula:
ARR =
Example
Calculation
Result
Measures the annual profitability of an investment as a percentage of
the initial investment
Provides a percentage return which can be compared to targeted
return
Focus is on profit which is the main goal of most business decisions
Easily understood
Doesn’t take into account time value of money
Doesn’t take into account timing of the cash flow
Average annual return or annual profit
Initial cost of investment
Investment is expected to earn cash flows of $10,000 annually for the
next five years ($50.000). Investment initially cost $20,000.
Therefore profit is $30,000 and annual profit is $6,000.
6,000
20,000
x 100
30%
Factors in assessing ARR percentage value
 The ARR on other projects (the opportunity costs)
 The minimum expected return set by the business
 The annual interest rates on loans. ARR needs to be greater than the interest costs on
borrowing. Even if the firm doesn’t need to borrow for the investment, there’s always an
opportunity cost of interest foregone by keeping the money in the bank.
NET PRESENT VALUE or Discounted Cash Flows
The two methods above, payback period and average rate of return, may both be applied to a
potential investment and give conflicting results. For example, project X is estimated to be
paid back in three years with an ARR of 15%. Is this better than project Y that will take four
years to pay back but will give an ARR of 18%. Net Present Value considers the size of the
cash flows and the timing of them. It does this by discounting cash flows.
NPV takes into account the time value of money. The present value of a future sum of money
depends on two factors:
 The higher the interest rate, the less value future cash in today’s money
 The longer into the future cash is received, the less value it has today.
Definition
Advantages
Disadvantages
Measures today’s value of the estimated cash flows resulting from an
investment
Takes into account the fact that money values change with time
Takes into account time value of money
Makes assumptions about interest rates
Calculating discounted cash flow is the most complex of the three
methods.
The following example, which uses smaller example figures!, is from the site:
Mathsisfun.com
http://www.mathsisfun.com/money/net-present-value.html - NetPresentValue
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There are some excellent YouTube clips that explain NPV well, for example ones entitled:
 Net present value explained
 What is NPV?
 Net present value ~ NPV.
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