Business Management 3.8 – INVESTMENT APPRAISAL
Investment: purchasing capital goods and improving existing fixed assets
INVESTMENT APPRAISAL – Evaluating the profitability or desirability of an investment project. Uses
quantitative and qualitative techniques that assess the financial feasibility of the project
Quantitative investment appraisal:
Initial capital cost (installation costs)
Estimated life expectancy
Residual value
Forecasted net returns (net cash flows) = returns – annual running costs
Forecasting cash flows in an uncertain environment
Cash inflows = annual revenues earned from the project
Cash outflows = annual operating costs
Long-term investments have more chances of being affected by external factors. All investment
decisions involve some risk due to its uncertainty
Quantitative techniques of investment appraisal
Payback period: length of time it takes for the net cash inflows to pay back the original
capital cost of the investment. Investment / Expected to pay back annually. Assumes that
cash flows are received evenly throughout the year.
additional cash inflow needed
x 12 months
annual cash flow∈that year
To compare between projects, to see if it will be payback within a certain period
Time for payback is important to businesses that borrowed finance (interest payments)
Capital has the opportunity cost
Longer time means more uncertainty
Some managers are risk-averse so quick payback reduces uncertainty
Future cash flows have less real value than cash flows today (inflation)
Advantages Disadvantages
Quick and easy Doesn’t measure overall profitability
Results easy understood (cash flow after payback period)
Concentrate on more accurate short- Priority to short return rather than
term forecasts of the project’s other profitable investments
profitability Doesn’t consider timing of the cash
To eliminate projects that give returns flows during payback period
too far in the future
Useful where liquidity is of greater
significance
Average rate of return (ARR): measures annual profitability of an investment as a
percentage of initial investment. it can expect an annual return of % on its investment.
Annual profit= (Average made from sum of net cash flow – investment)/years
Assess within it complies with minimum criterion rate and annual interest from loans.
Criterion rate: minimum level set by management for investment appraisal results for a
project to be accepted
annual profit ( net cash flow)
ARR ( % )= x 100
initial capital cost
1
Investment: purchasing capital goods and improving existing fixed assets
INVESTMENT APPRAISAL – Evaluating the profitability or desirability of an investment project. Uses
quantitative and qualitative techniques that assess the financial feasibility of the project
Quantitative investment appraisal:
Initial capital cost (installation costs)
Estimated life expectancy
Residual value
Forecasted net returns (net cash flows) = returns – annual running costs
Forecasting cash flows in an uncertain environment
Cash inflows = annual revenues earned from the project
Cash outflows = annual operating costs
Long-term investments have more chances of being affected by external factors. All investment
decisions involve some risk due to its uncertainty
Quantitative techniques of investment appraisal
Payback period: length of time it takes for the net cash inflows to pay back the original
capital cost of the investment. Investment / Expected to pay back annually. Assumes that
cash flows are received evenly throughout the year.
additional cash inflow needed
x 12 months
annual cash flow∈that year
To compare between projects, to see if it will be payback within a certain period
Time for payback is important to businesses that borrowed finance (interest payments)
Capital has the opportunity cost
Longer time means more uncertainty
Some managers are risk-averse so quick payback reduces uncertainty
Future cash flows have less real value than cash flows today (inflation)
Advantages Disadvantages
Quick and easy Doesn’t measure overall profitability
Results easy understood (cash flow after payback period)
Concentrate on more accurate short- Priority to short return rather than
term forecasts of the project’s other profitable investments
profitability Doesn’t consider timing of the cash
To eliminate projects that give returns flows during payback period
too far in the future
Useful where liquidity is of greater
significance
Average rate of return (ARR): measures annual profitability of an investment as a
percentage of initial investment. it can expect an annual return of % on its investment.
Annual profit= (Average made from sum of net cash flow – investment)/years
Assess within it complies with minimum criterion rate and annual interest from loans.
Criterion rate: minimum level set by management for investment appraisal results for a
project to be accepted
annual profit ( net cash flow)
ARR ( % )= x 100
initial capital cost
1
