Investment appraisal

Business A2 · Finance and accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Investment appraisal means judging whether a capital project, such as a new machine or factory, is worth its cost. It is needed because the spending is large, hard to reverse and paid back over many years. It also lets managers compare projects on the same basis.

Payback measures how quickly the cost is recovered. Accounting rate of return (ARR) gives the average yearly profit as a percentage of the investment. Net present value (NPV) discounts future cash flows, because money received later is worth less than money received today.

All three rely on forecasts, which may be wrong. Qualitative factors such as jobs, the environment and reputation must also be weighed.

Rules to remember

Payback period = the time taken for net cash inflows to recover the initial cost; a shorter payback means less risk.
ARR (%) = average annual profit ÷ average investment × 100
average annual profit = (total net cash inflows − initial cost) ÷ number of years; average investment = (initial cost + residual value) ÷ 2
present value = cash flow × discount factor
NPV = total of the present values of the net cash inflows − initial cost; accept if NPV is positive.
A higher discount rate gives a lower NPV.
Payback ignores cash flows after the payback point and ignores profitability; payback and ARR ignore the time value of money.

Common mistake

Students add up the cash flows without discounting them and call the result NPV. Multiply each year's cash flow by its discount factor first, then subtract the initial cost.

Worked example

A machine costs $60 000 and brings in net cash flows of $25 000 a year for three years. The discount factors at 10% are 0.909, 0.826 and 0.751. Find the payback period and the NPV.

After 2 years 50 000 is recovered, leaving 10 000: 10 000 ÷ 25 000 × 12 = 4.8 months, so payback = 2 years 4.8 months.
Present values: 25 000 × 0.909 = 22 725; 25 000 × 0.826 = 20 650; 25 000 × 0.751 = 18 775.
Total present value = 22 725 + 20 650 + 18 775 = $62 150.
NPV = 62 150 − 60 000 = $2 150.

Answer: Payback = 2 years 4.8 months; NPV = +$2 150, so on these figures the project is worth accepting.

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INVESTMENT APPRAISAL

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