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Understanding Investment Appraisal Methods

Mar 30, 2025

Lecture on Investment Appraisal Methods

Introduction

  • Lecture from Open Tuition, aimed to benefit from their lecture notes.
  • Fourth and last lecture on Chapter 7.
  • Focus on investment appraisal methods.

Main Investment Appraisal Methods

  • Discounted Cash Flow (DCF): Most common method, crucial for investment decisions.
    • Includes NPV (Net Present Value) and IRR (Internal Rate of Return).
  • Alternative Approaches: Although not frequently tested, important to be aware of.

Accounting Rate of Return (ARR)

  • Definition: A profit measure, unlike DCF which focuses on cash flows.
    • Important for understanding profitability since stakeholders focus on profits.
    • Calculated as average profit per year as a percentage of average book value.
  • Example Calculation:
    • Machine cost: $80,000, scrap value: $10,000, life: 4 years.
    • Operating cash flows: $20K, $30K, $40K, $10K.
    • Total cash flow: $100,000.
    • Depreciation: Total $70,000 ($80,000 - $10,000 scrap value).
    • Average profit: $30,000 / 4 = $7,500 per year.
    • Average book value calculation considering depreciation and scrap value.
    • ARR: $7,500 / $45,000 = 16.67%.
  • Usage:
    • Compared against a target return or Return on Capital Employed (ROCE).
    • Simple method but useful for basic profit evaluation.

Payback Period

  • Definition: Measures the time taken to recoup initial investments in cash terms.
  • Example Calculation:
    • Investment: $80,000.
    • Yearly cash inflows: $20K, $30K, $40K.
    • Calculation: Year 1 ($20K), Year 2 ($30K = $50K total), Year 3 ($40K = $90K total).
    • Payback achieved in less than 3 years, specifically 2.75 years assuming even cash inflow in Year 3.
  • Usage:
    • Companies set a target payback period (e.g., within 4 years).
    • Highlights the importance of early cash recovery due to estimation uncertainties.
    • Shorter payback periods are preferred for reducing risk.

Conclusion

  • Three methods discussed:
    1. Discounted Cash Flow (NPV & IRR).
    2. Accounting Rate of Return (simple profitability measure).
    3. Payback Period (focus on cash recovery).
  • Importance of using a range of metrics for comprehensive investment appraisal.
  • Upcoming chapters will focus on deriving cash flows for DCF analysis.

This lecture concludes the F2 revision on investment appraisal methods, highlighting the diversity and complementary nature of different appraisal techniques.

Full transcript