3.8: Investment appraisal

What is it

Investment Appraisal
Investment refers to purchasing assets with the potential for future financial benefits. Investment appraisal is the process of evaluating the financial costs and benefits of an investment decision. It helps assess the risks involved in investment decision-making. The three main methods of investment appraisal are:
Payback Period: Calculates how long it takes an investment to recoup its initial cost.
Average Rate of Return: Determines the average annual profit generated by an investment as a percentage of the initial cost.
Net Present Value (NPV): Calculates the present value of an investment's future cash flows, discounted at a specific rate.

The payback period (PBP) is the time it takes an investment to recoup its initial cost through profits. It's calculated by dividing the initial investment cost by the monthly contribution.
Example:
Initial investment: $10,000
Annual revenue: $6,000
Payback period: $10,000 / ($6,000 / 12 months) = 20 months
Advantages of PBP:
Easy to understand and calculate.
Emphasizes short-term liquidity.
Suitable for risky projects.
Disadvantages of PBP:
Ignores cash flows after the payback period.
Doesn't consider time value of money.
May favor short-term projects over long-term ones.

The average rate of return (ARR) is a method to calculate the average profit on an investment as a percentage of the initial investment. It's calculated by dividing the total profit during the project's lifespan by the initial investment cost and multiplying by 100.
ARR is useful for:
Comparing returns on different investment projects.
Benchmarking against base interest rates to assess risk.
Advantages of ARR:
Easy to understand and calculate.
Enables direct comparison of returns.
Disadvantages of ARR:
Ignores the timing of cash flows.
Relies on accurate estimates of project lifespan.
May be less reliable for long-term forecasts.

The time value of money concept states that money received today is worth more than money received in the future due to the potential to earn interest or invest it.
Key points:
Present Value vs. Future Value: Money received today can be invested to grow over time.
Discounting: The process of converting future cash flows to their present value using a discount factor.
Discount Factor: Represents inflation and interest rates.
Net Present Value (NPV): Calculates the present value of future cash flows minus the initial investment cost.
NPV Decision: A positive NPV indicates a financially viable investment.