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Investment Appraisal Techniques Explained

Investment appraisal is a process used to analyze whether investment projects are worthwhile. There are three main techniques used: payback period, average rate of return, and net present value. The payback period calculates how long it will take for revenues to cover costs, with shorter periods preferred. Average rate of return expresses annual profit as a percentage of investment, with higher percentages preferred. Net present value discounts future cash flows to consider the time value of money, with higher present values preferred. Investment appraisal helps firms evaluate projects and make strategic investment decisions.

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52 views4 pages

Investment Appraisal Techniques Explained

Investment appraisal is a process used to analyze whether investment projects are worthwhile. There are three main techniques used: payback period, average rate of return, and net present value. The payback period calculates how long it will take for revenues to cover costs, with shorter periods preferred. Average rate of return expresses annual profit as a percentage of investment, with higher percentages preferred. Net present value discounts future cash flows to consider the time value of money, with higher present values preferred. Investment appraisal helps firms evaluate projects and make strategic investment decisions.

Uploaded by

MK Asuncion
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Investment appraisal is a process of analysing whether an investment project is worthwhile or

not. It includes techniques that assess the profitability of investing in a long-term project.
Investment appraisal is an analysis conducted to help firms and their managers in specific
situations. Here are some cases where it is adopted:

 When a firm has to decide on whether to take on a project or not.


 When a firm has to decide on which project to choose.
 When there is a largely irreversible commitment of resources associated with a project.
 When a project is associated with a significant degree of risk.

In order to be successful, the analysis needs to be based on strategic planning, in line with
the organizational objectives of a company. It should be based on reliable forecasting as it is
necessary to know the associated costs and likely revenues of the venture.

Investment Appraisal Methods and Examples

There are three techniques of investment appraisal:

 Payback period,

 The average rate of return,

 Net present value.

Payback Period

The payback period is the length of time it will take a project to return the money invested. It
calculates how long it will take for the revenues to cover the costs.

(if uneven cash flows)

(if even cash flows)


The shorter the payback period, the faster the money invested in a project will be returned and
the less time a firm's money will be at risk. Typically, a project with the shortest payback period
would be chosen.

Average Rate of Return (ARR)

The average rate of return (ARR) is the average annual return (profit) of an investment. It is
expressed as a percentage of the original sum invested.
The formula for calculating ARR is the following:
The higher the average rate of return, the higher the return on investment. Typically, a project
with the highest ARR would be chosen.

Net Present Value (NPV)

Net present value (NPV) is the current value of the future expected cash flows. It considers the
time value of money. To calculate NPV, discounted cash flows are used.

Discounted cash flows consider the interest that the money could have accumulated if it were
sitting in the bank earning interest. That is why the amount by which the cash flow will be
discounted depends on the interest rate.

A firm is considering investing in a project that requires an investment £ 1,900,000. It is then


expected to give revenues as follows:

Year Revenue

1 £ 200,000

2 £ 300,000

3 £ 350,000

4 £ 350,000

5 £ 400,000

6 £ 400,000

7 £ 300,000

8 £ 100,000

Total revenue £ 2,400,000


Since total revenue is £2,400,000 and investment is £ 1,900,000, then the profit will be £
500,000.

However, since money loses value over time, we need to consider the rate of interest.
The discount factor in the table is 5%.

Year Return x Discount factor = Present value


1 £ 200,000 x 0.952 = £ 190,400
2 £ 300,000 x 0,907 = £ 272,100
3 £ 350,000 x 0.864 = £ 302,040
4 £ 350,000 x 0.823 = £ 288,050
5 £ 400,000 x 0.784 = £ 313,600
6 £ 400,000 x 0.746 = £ 298,400
7 £ 300,000 x 0.711 = £ 213,300
8 £ 100,000 x 0.677 = £ 67,700
Total present value £ 1,945,950
Since total present value is £ 1,945,950 and the investment was £ 1,900,000, then the net present
value will be £45,950.

The higher the net present value, the higher the current value of the future expected cash flows.
Typically, a project with the highest NPV would be chosen.

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