Investment Appraisal

Definition

• Investment: Spending now with the hope of future returns.
• Investment Appraisal: Analyzing the profitability of an investment project using quantitative and qualitative factors.

Key Components

• Quantitative Factors: Costs, potential profits, cash inflows and outflows.
• Qualitative Factors: Environmental impact, business aims, risk appetite.

Factors Influencing Investment Decisions

• Initial capital cost
• Project life expectancy
• Residual value of investment
• Forecasted cash inflows and outflows
• Impact on community and environment
• Business aims and objectives
• Risk tolerance of managers

Methods of Investment Appraisal

1. Payback Period

• Calculates time to recoup original investment from net cash inflows.
• Pros: Quick, easy, useful for comparing projects.
• Cons: Too simplistic, doesn't consider long-term flows.

2. Accounting Rate of Return (ARR)

• Reflects percentage return expected on investment compared to cost.
• Pros: Focuses on overall net cash flow, easy to understand.
• Cons: Ignores timing of cash flows.

3. Discounted Payback Method

• Similar to payback, but considers discounted cash flows.
• Accounts for time value of money.

4. Net Present Value (NPV)

• Uses discounted cash flows to calculate current value of all future cash flows.
• Pros: Considers size and timing of flows, time value of money.
• Cons: Complex, can complicate project comparison.

5. Internal Rate of Return (IRR)

• Discount rate leading to NPV of zero.
• Higher IRR indicates more profitable investment.

Limitations of Investment Appraisal

• Numerical methods may ignore qualitative factors.
• Requires up-to-date and accurate data.
• Risk assessment challenges, varying attitudes toward risk within an organization.