What is Investment Appraisal?
Investment appraisal evaluates whether a capital project is financially worthwhile. Businesses use methods like NPV, payback period, ARR and IRR to compare competing projects and make sound investment decisions.
Investment appraisal is the process of assessing capital investments using financial methods (NPV, ARR, payback period, IRR) to determine profitability, risk and strategic fit.
- •Payback period — time to recover initial outlay
- •ARR — average annual profit as % of capital
- •Simple to calculate
- •Ignores time value of money
- •NPV — present value of all cash flows
- •IRR — discount rate where NPV = 0
- •Accounts for time value of money
- •More complex calculation
Step-by-step worked examples
A company invests £100,000 and receives £30,000 annually for 5 years. Calculate the payback period.
Annual cash inflow = £30,000 Years to recover £100,000 = £100,000 ÷ £30,000 = 3.33 years Payback period = 3 years 4 months (0.33 × 12)
Project A costs £50,000; Project B costs £80,000. Both yield profits. Which metric helps choose between capital-constrained options?
Use profitability index = NPV ÷ Initial outlay Higher profitability index = better return per £ invested Or calculate NPV for each and choose highest NPV
A project requires £90,000 investment and yields £40,000 annual profit for 3 years. Calculate ARR.
Total profit = £40,000 × 3 = £120,000 Net profit = £120,000 − £90,000 = £30,000 ARR = (£30,000 ÷ £90,000) × 100 = 33.3%
Flashcards
Quick quiz
Q1.Payback period is most useful for assessing...
Q2.NPV is preferred by theorists because it...
Q3.A £100,000 investment yields £20,000 annually. Payback period is...
Q4.Which method ignores the time value of money?
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Common mistakes
Assuming payback period equals total profit. — Correct: Payback period is the time to recover initial capital; it says nothing about total profit.
Ignoring time value of money in investment decisions. — Correct: Money in the future is worth less than money today due to opportunity cost and inflation.
Choosing ARR over NPV for strategic capital decisions. — Correct: NPV is theoretically superior for capital budgeting because it accounts for time value of money.
Not considering the initial capital outlay size. — Correct: Use profitability index (NPV ÷ initial outlay) to compare projects of different scales fairly.
FAQ
What is investment appraisal?
Assessment of capital investments using financial methods like NPV, ARR, payback period and IRR to evaluate profitability and make investment decisions.
What is the payback period method?
The time it takes for a project to generate cash inflows equal to the initial investment. Simple but ignores time value of money.
Why is NPV considered the best method?
NPV accounts for the time value of money and provides a clear monetary measure of project value. It is theoretically superior to other methods.
What does IRR stand for?
Internal Rate of Return — the discount rate at which NPV equals zero, representing the project's return as a percentage.