1. Unit 3.8 – Investment Appraisal

2. You should be able to . . .
Calculate and evaluate the payback period as an investment appraisal method
Calculate and examine the average rate of return as an investment appraisal method
Calculate and discuss the net present value method as an investment appraisal method (HL only)

3. Introduction
Investment appraisal – quantitative techniques used to evaluate the viability of an investment proposal.
Attempts to assess and justify the capital expenditure
Three methods presented:
Payback period
Average Rate of Return
Net Present Value

4. Payback Period
Estimates the length of time required for an investment project to pay back its initial cost outlay.
Calculation of Payback Period
Initial Investment cost / annual cash flow from investment
Example – bottom of page 233 – payback period – 4 years.
Table 3.1 page 234 illustrates the expected cash flow from the new machine

5. Payback - continued
How to figure exactly when enough revenue is generated to pay back the initial investment
Last year - extra cash inflow required / Annual cash flow in year 4 X 12 months = number of months required in last year.

6. Advantages of Payback Period
Simple and fast to calculate
Useful in rapidly changing industries such as technology
Helps firms with cash-flow problems – can choose which investment projects can be paid off quicker
This short-term measure is less prone to the inaccuracies of long-term forecasting
Business managers can easily comprehend and use the results obtained.

7. Disadvantages of Payback
Doesn’t consider the cash earned after the payback period
It ignores the overall profitability of an investment project by focusing on only how fast it will pay back
The annual cash flows could be affected by unexpected external changes

8. Average Rate of Return
Measures the annual net return on an investment at a percentage of its capital cost.
Measures the profitability per annum generated by a project over a period of time AKA Accounting Rate of Return
First calculate Total Returns – Capital Cost / Years of Usage. That number divided by Capital Cost X 100
Example page 235

9. Advantages of ARR
Shows the profitability of an investment project over a given period of time
Unlike the payback period, makes use of all cash flows in a business
Allows for easy comparisons with other competing projects
A business can use its own criterion rate and check this with the ARR of a project to determine viability of project

10. Disadvantages of the ARR
Since it considers a longer time period, there are likely to be forecasting errors
Doesn’t consider the timing of cash flows – two projects might have the same ARR but one could pay back more quickly
The effects on the time value of money are not considered

11. End of Chapter Student workpoint 3.17 - #1 and #2 – page 238
Choose 1 of 2
Page 215 – Woolman Windows
Page 232 – New Philanthropy Foundation