Investment Appraisal
- Every investment a business makes, whether buying new equipment, launching a product, or expanding operations, comes with costs, risks, and expected returns.
- Investment appraisal helps businesses decide if an investment is worth it by using financial techniques to measure profitability and risk.
Investment Appraisal
Investment appraisal is the process of evaluating the potential profitability and risks of an investment to determine its financial viability.
Key Methods of Investment Appraisal
- Payback Period: Measures how long it takes for an investment to recover its initial cost from cash inflows.
- Accounting Rate of Return (ARR): Evaluates profitability by comparing average annual profit to initial investment.
- Net Present Value (NPV): Calculates the present value of future cash flows, considering the time value of money.
Payback Period: How Long Until You Break Even?
Payback Period
The payback period is the amount of time it takes for an investment to generate enough cash flows to recover the initial investment cost.
- As a business owner considering investing in something new, you need to know:
- How long it will take to recover your investment.
Investment appraisal helps businesses make informed decisions by evaluating the financial viability of projects.
How to Calculate the Payback Period
- Cumulative Cash Flow Method:
- Track cash inflows year by year.
- Identify when cumulative cash inflows equal the initial investment.
- Formula for Partial Years:
$$\text{Payback Period} = \text{Number of full years} + \frac{\text{Amount still needed}}{\text{Cash inflow in next year}}$$
Step-by-Step Calculation For Cumulative Cash Flow Method
Consider a business that invested $400,000 in the project.
| Year | Cash Inflow ($) | Cumulative Cash Flow ($) |
|---|---|---|
| 1 | 100,000 | 100,000 |
| 2 | 100,000 | 200,000 |
| 3 | 200,000 | 400,000 |
| 4 | 300,000 | 700,000 |
Solution
- Initial Investment: The business invested $400,000 in the project.
- Cumulative Recovery: By the end of Year 3, the cumulative cash inflow reaches $400,000, meaning the investment is fully recovered at this point.
- Payback Period: Since the full investment is recovered exactly at the end of Year 3, the payback period is 3 years.
- If the initial investment were higher, say $450,000, the business would need an additional $50,000 from Year 4’s cash inflow.
- In that case, we’d calculate the extra months needed within Year 4.
Step-by-Step Calculation For Partial Years Method
Consider a business that invested $450,000 in the project and by the end of Year 3, it had recovered $400,000 through cumulative cash inflows.
| Year | Cash Inflow ($) | Cumulative Cash Flow ($) |
|---|---|---|
| 1 | 100,000 | 100,000 |
| 2 | 100,000 | 200,000 |
| 3 | 200,000 | 400,000 |
| 4 | 300,000 | 700,000 |
Solution
- Initial Investment: The business invested $450,000 in the project. By the end of Year 3, it had recovered $400,000 through cumulative cash inflows.
- Remaining Amount to Recover:
- At the end of Year 3, there is still $50,000 left to recover (\$450,000 - \$400,000).
- Calculating Partial-Year Payback:
- In Year 4, the total cash inflow is $300,000, meaning the business earns an average of $25,000 per month ($300,000 ÷ 12 months).
- To recover the remaining $50,000, the business needs: 50,000 ÷ 25,000 = 2 months
- Final Payback Period: The investment is fully recovered in 3 years and 2 months.
Pros and Cons of the Payback Period
| Advantages | Disadvantages |
|---|---|
| Simple and quick to calculate | Ignores cash flows after payback |
| Useful for businesses needing fast returns | Doesn’t measure total profitability |
| Helps firms with cash flow issues choose faster-paying investments | Doesn’t account for the time value of money |
Payback Period is best for businesses with liquidity concerns or rapidly changing industries where fast recovery is crucial.
- Don't assume a shorter payback period always means a better investment.
- It only shows how quickly the initial cost is recovered, not the total profit.
Average Rate of Return (ARR): Measuring Profitability
Average Rate of Return
The Average Rate of Return (ARR) measures the profitability of an investment as a percentage of the initial or average investment cost. It helps businesses compare the potential returns of different investment projects.
- ARR helps answer: "How profitable is this investment compared to its cost?"
- It focuses on profitability rather than speed.
How to Calculate ARR
- Calculate total profit: Subtract the initial investment from total cash inflows.
- Find the average annual profit: Divide total profit by the investment's lifespan.
- Use the ARR formula:
$$\text{ARR} = \left(\frac{\text{Average annual profit}}{\text{Initial investment}}\right) \times 100$$
Suppose a new machinery is purchased for $40,000 to generate the following cash flow fort the next 3 years:
| Year | Net Cash Flow ($) |
|---|---|
| 0 | (40,000) |
| 1 | 16,000 |
| 2 | 20,000 |
| 3 | 22,000 |
Compare the ARR to the interest rate offered by banks. If the ARR is lower, the investment may not be worth the risk.
- The total net cash flow over 3 years is $58,000.
- Forecasted profit = \$58,000 - \$40,000 = \$18,000
- Average annual profit = \$18,000 / 3 = \$6,000
- Hence, the ARR = \$6,000 / \$40,000 x 100 = 15%.
- Students often forget to subtract the initial investment when calculating total profit for ARR.
- Double-check your calculations.
- Compare ARR to a company’s target return or bank interest rates.
- If ARR is higher than other options, the investment is financially attractive.
- For example, comparing this to any other investment that fetches below 15%, say a savings account that usually yields ~3.5%, this investment is highly profitable.
Pros and Cons of ARR
| Advantages | Disadvantages |
|---|---|
| Considers total profitability | Ignores the timing of cash flow |
| Easy comparison with other projects | Doesn’t consider cash flow fluctuations |
| More useful for long-term investments | Ignores time value of money |
ARR is best for businesses focusing on long-term profitability rather than quick returns.
When To Use Payback Period and ARR
| Method | Best for |
|---|---|
| Payback Period | When liquidity and fast recovery are priorities (e.g., startups, tech industries). |
| ARR | When profitability is more important than speed (e.g., long-term infrastructure projects). |
- How does the payback period differ from ARR in terms of focus?
- What are the main limitations of each method?
- Can you think of a scenario where a project with a longer payback period might still be preferable?
- To what extent do quantitative methods like payback period and ARR capture the true value of an investment?
- Consider the role of environmental impact such as ESG and "net-zero" measures.
Make sure you align your evaluation of an Investment appraisal with the business's goals and risk tolerance.
