3.8 Investment Appraisal
• Investment appraisal uses a range of quantitative decision-making techniques to assess investment projects.
Payback Period: Advantages Disadvantages
• Easy to calculate and understand • It ignores the long-term profitability of
• tells us the number of year and • The payback period is important an investment. A more desirable
months the investments will take to for companies that suffer from investment may be overlooked as it
pay for itself cash flow problems. This may has a longer payback period.
• cash flow is estimated annually to include small businesses such as • There is no consideration given to
calculate the months and year in
which the cash flows will cover the sole traders, or those trying to what happens after the payback
cost of investment. survive a recession. period. For example, the useful life of
• Net cash flow = cash inflows - cash • There is an emphasis on speed of the investment is completely
outflows return and it can be used for fast- disregarded.
• When the cumulative net flows are changing markets. • Potential profits are ignored entirely.
equal to the initial investment cost, • It is used in buying technology • Money loses value over time, and
we say the payback period has and machinery, which becomes payback period calculations do not
been reached. outdated rapidly. take this into account.
Average Rate of Return: Net Present Value:
• tells us our future cash flows expressed as an average • with estimated cash flow data from an investment project,
return on the money we spent on the investment. we can work out what the future value of the investment
• This investment appraisal technique allows the annual will be. We need to do this because money loses value
forecast profits from an investment to be turned into a over time.
percentage of the initial investment cost. • net present value, uses discount factors
• A desirable average rate of return is above the bank • Discount rates allows future incomes to be expressed in
base rates. terms of what their present value is today or convert future
earnings to today's value of money.
Advantages
• Present value = Net cash flow × Discount factor
• It focuses on profitability, which is an objective of • Net present value = Total discounted cash flows - Original
most private sector firms. cost
• It allows easy comparison with other investment Advantages
opportunities.
• It takes into account the effects of inflation and the
• It takes into account all net flows for the expected opportunity cost of lost interest.
lifetime of the project.
• It looks at all future net flows of the project.
Disadvantages • Use of discounting reduces the impact of long-term, less
• The timing of cash flow is ignored. A large inflow in predictable cash flows.
Year 4 is given the same value as one that comes Disadvantages
tomorrow. • It is more complex than other methods
• As with the payback period discussed previously, this • Use of different discount rates can result in widely
method does not take into account the fact that different results.
money loses value over time because of two factors: • There is no way of knowing which discount rate is
time and interest. correct.
Quantitative v Qualitative:
• Not all decisions are made
using statistics.
• Many entrepreneurs invest in
projects because they have a
feeling that it is the right thing to
do rather than because the
figures tell them it is right
Problems with Forecasts:
• It is important to remember that all investment appraisals are forecasts. Future inflows and outflows of a project
have to be estimated.
• Investment appraisal uses a range of quantitative decision-making techniques to assess investment projects.
Payback Period: Advantages Disadvantages
• Easy to calculate and understand • It ignores the long-term profitability of
• tells us the number of year and • The payback period is important an investment. A more desirable
months the investments will take to for companies that suffer from investment may be overlooked as it
pay for itself cash flow problems. This may has a longer payback period.
• cash flow is estimated annually to include small businesses such as • There is no consideration given to
calculate the months and year in
which the cash flows will cover the sole traders, or those trying to what happens after the payback
cost of investment. survive a recession. period. For example, the useful life of
• Net cash flow = cash inflows - cash • There is an emphasis on speed of the investment is completely
outflows return and it can be used for fast- disregarded.
• When the cumulative net flows are changing markets. • Potential profits are ignored entirely.
equal to the initial investment cost, • It is used in buying technology • Money loses value over time, and
we say the payback period has and machinery, which becomes payback period calculations do not
been reached. outdated rapidly. take this into account.
Average Rate of Return: Net Present Value:
• tells us our future cash flows expressed as an average • with estimated cash flow data from an investment project,
return on the money we spent on the investment. we can work out what the future value of the investment
• This investment appraisal technique allows the annual will be. We need to do this because money loses value
forecast profits from an investment to be turned into a over time.
percentage of the initial investment cost. • net present value, uses discount factors
• A desirable average rate of return is above the bank • Discount rates allows future incomes to be expressed in
base rates. terms of what their present value is today or convert future
earnings to today's value of money.
Advantages
• Present value = Net cash flow × Discount factor
• It focuses on profitability, which is an objective of • Net present value = Total discounted cash flows - Original
most private sector firms. cost
• It allows easy comparison with other investment Advantages
opportunities.
• It takes into account the effects of inflation and the
• It takes into account all net flows for the expected opportunity cost of lost interest.
lifetime of the project.
• It looks at all future net flows of the project.
Disadvantages • Use of discounting reduces the impact of long-term, less
• The timing of cash flow is ignored. A large inflow in predictable cash flows.
Year 4 is given the same value as one that comes Disadvantages
tomorrow. • It is more complex than other methods
• As with the payback period discussed previously, this • Use of different discount rates can result in widely
method does not take into account the fact that different results.
money loses value over time because of two factors: • There is no way of knowing which discount rate is
time and interest. correct.
Quantitative v Qualitative:
• Not all decisions are made
using statistics.
• Many entrepreneurs invest in
projects because they have a
feeling that it is the right thing to
do rather than because the
figures tell them it is right
Problems with Forecasts:
• It is important to remember that all investment appraisals are forecasts. Future inflows and outflows of a project
have to be estimated.
