3.8 Investment Appraisal

Investment - The purchase of an asset with the potential to yield future financial benefits.

‍Investment Appraisal - Quantitative techniques used to calculate the financial costs and benefits of an investment decision. The three main methods of investment appraisal are: payback period, average rate of return and net present value.

Payback Period - the amount of time needed for an investment project to earn enough profit to repay the initial cost of the investment.

PBP = initial investment cost / contribution per month

Advantages

Forecasting - Businesses can measure how long it would take for the cash outflow used in the investment to be recouped, allowing it to forecast potential cash flow problems.

ROI - Businesses can determine whether they will be likely to breakeven on the purchase of an asset before it becomes obsolete and needs to be replaced.

Disadvantages

Static - Makes the assumption that contribution per month will be constant, ignoring changing market demands and business environments.

Average Rate of Return - Calculates the average profit on an investment project as a percentage of the amount invested. The ARR is usually compared to the market interest rate to assess whether the rewards of the investment outweigh the risks.

ARR = (total profit of investment / number of years of project) / initial amount invested x 100

‍Net Present Value - The sum of all discounted cash flow minus the cost of a particular investment project. Due to inflation, money perceived in the future is worth less than if it were today, the net present value adjusts the potential cash inflow of the investment to projected inflation.

NPV = sum of present values - cost of investment

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