3.8 Investment Appraisal
refers to the quantitative techniques used in evaluating the viability or attractiveness of an investment proposal.
The payback period
This method estimates the length of time required for an investment project to pay back its initial cost outlay
Payback period =
initial investment cost / annual cash flow from investment
Advantages
simple and fast to calculate
Business managers can easily comprehend and use the results obtained.
it is less prone to the inaccuracies of long-term forecasting.
Disadvantages
ignores the overall profitability of an investment project
does not consider the cash earned after the payback
The annual cash fows could be affected by unexpected external changes in demand
The average rate of return
This method measures the annual net return on an investment as a percentage of its capital cost
Average rate of return (ARR)=(((total returns - capital cost)/years of usage)/capital cost) x 100
Advantages
The ARR shows the profitability of an investment project over a given period of time
Unlike the payback period, it makes use of all the cash flows in a business
It allows for easy comparisons with other competing projects, or better allocation of investment funds.
Disadvantages
The effects on the time value of money are not considered.
It does not consider the timing of cash inflows. Two projects might have the same ARR but one could pay back more quickly despite this.
Since it considers a longer time period or useful life of the project, there are likely to be forecasting errors. Long-term forecasts decrease the accuracy of results.