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Investment Appraisal Fundamentals

Concept and Need

Why Investment Appraisal Matters

Investment appraisal is the process businesses use to assess whether an investment project, such as buying new equipment or expanding capacity, is worthwhile. Capital projects involve significant costs and risks. Appraisal helps ensure scarce resources are allocated efficiently to projects that generate adequate returns and align with business goals.

Payback Period Calculation

Initial Investment Recovery Time
The method calculates how long it takes to recover the initial investment from net cash inflows. Calculation: Add annual cash flows until total equals the initial investment.

Payback Interpretation

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Interpretation: Projects with shorter payback periods are preferred as they recover capital quicker, reducing risk. It is simple and useful for assessing liquidity risk and project speed.

Accounting Rate of Return (ARR)

ARR = (Average Annual Profit ÷ Average Investment) × 100
Measures average annual profit as a percentage of average investment. Higher ARR suggests a more profitable project.

Basic Method Limitations

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Strengths

Payback is simple and quickly assesses liquidity risk. ARR uses accounting profit and is straightforward to calculate.

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Weaknesses

Payback ignores profitability after the recovery period. Both Payback and ARR ignore the timing of cash flows.

Net Present Value (NPV) Fundamentals

NPV accounts for the time value of money and is considered the most precise appraisal method.

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Meaning

Discounts future cash flows back to their present value using the cost of capital.
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Calculation

Sum the present values of future cash inflows and subtract the initial investment.
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Decision Rule

If NPV is positive, the project is expected to add value; if negative, reject the project.
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Advantages

Considers time, risk, and total profitability, making it the most accurate appraisal method.

Decision Factors

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Quantitative Impact

Decisions are often based on criteria such as shortest payback, highest ARR, or positive NPV, focusing purely on numerical results.

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Qualitative Factors

These include strategic fit, environmental impact, employee relations, market conditions, and risks not captured by the numbers.

Comparison and Strategy

Understanding the limitations of each method informs how managers approach complex investment decisions.

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Why don't businesses rely solely on NPV if it's the most mathematically precise?
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Because each method has strengths and weaknesses. Payback is simple but limited. NPV is complex. Businesses often use a combination for robust decisions.
Investment Appraisal Deck
Term
Investment Appraisal

What is investment appraisal?

Answer
Definition

The process of assessing whether an investment project is worthwhile.

Term
Importance of Investment Appraisal

Why is investment appraisal important?

Answer
Reason

It helps allocate scarce resources efficiently and manage costs and risks.

Term
Payback Period Method

What does the payback period method measure?

Answer
Definition

The time it takes to recover the initial investment from net cash inflows.

Term
ARR Calculation

How do you calculate ARR?

Answer
Formula

ARR = (Average Annual Profit ÷ Average Investment) × 100.

Term
Limitation of Payback Method

What is a key limitation of the payback method?

Answer
Limitation

It ignores profitability after the payback period and timing of cash flows.

Term
NPV vs Payback & ARR

How does Net Present Value (NPV) differ from payback and ARR?

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Difference

NPV discounts future cash flows to present value, considering time and risk.

Term
Good Project Indicator

What indicates a good project according to NPV?

Answer
Sign

A positive NPV means the project adds value and is financially worthwhile.

Term
Qualitative Factors

Name one qualitative factor in investment appraisal.

Answer
Examples

Strategic fit, environmental impact, employee relations, market conditions, or risks.

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Use of Multiple Methods

Why do businesses use multiple appraisal methods?

Answer
Reason

To balance the strengths and weaknesses of each method for more accurate decisions.

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💼 Investment Appraisal Quiz

1. What does the payback period measure?

Payback period calculates how long it takes to recoup the initial cost from net cash inflows.

2. Which method accounts for the time value of money?

NPV discounts future cash flows to present value, reflecting the time value of money.

3. How is ARR calculated?

ARR measures average annual profit as a percentage of the average investment.

4. Which is a limitation of the payback period?

Payback method does not consider cash flows after the investment is recovered.

5. A project with a negative NPV should:

Negative NPV means the project is expected to reduce value, so it should be rejected.

📊 Results

  • Notes and Quiz
  • Business
  • AS & A Level
  • Accounting & Finance
  • CAIE