INVESTMENT APPRAISAL

What is investment appraisal?

investment appraisal: evaluating the profitability of an investment project

PAYBACK METHOD

payback period: length of time it takes for the net cash inflows to pay back the original capital cost of the
investment

Payback period = initial investment cost / annual cash flow from investment

PPI = initial investment / cash inflow per period

In which month will be paid back the initial investment?

AVERAGE RATE OF RETURN (ARR)

average rate of return (ARR): measures the annual profitability of an investment as a percentage of the
initial investment.

TRP(%) = x 100
ACTIVITY 01

Year Boston Project Cumulative cash flows ($)

0 (130,000) (130,000)
1 60,000 (70,000)
2 60,000 (10,000)
3 60,000

PPI = Initial investment /Cash inflow per period

ARR =

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ACTIVITY 02

Calculate the PPI and the ARR with the following data.

Year Atlanta project Cash flow Cumulative cash flows ($)

0 (130,000) (130,000)
1 80,000 (50 000)
2 60,000 10 000
 3 20,000 .

PPI =

ARR =

ACTIVITY # 3

A large retail business has the following forecasted net cash flows for a major project.

▪Calculate the payback period.

▪Calculate the ARR.

YEAR NET CASH FLOWS Cumulative cash flows ($)

0 (40,000) (40,000)
1 15,000
2 30,000
3 10,000
4 5,000

PPI =

ARR =
ACTIVITY # 4

• A project costs $500,000 and is expected to generate the following cash flows in
the first four years: $ 300,000, $ 150,000, $ 150,000, $ 100,000.
• Calculate the payback period for the project and the ARR

YEAR NET CASH FLOWS CUMULATIVE

0 (500,000) (500,000)
1 300,000
2 150,000
3 150,000
4 100,000

PPI =

ARR =

ACTIVITY # 5

• Another construction engineer aims to invest $300,000 in a new timber-cutting machine. The
machine is expected to generate the following cash flows in the first four years: $60,000, $80,000,
$100,000 and $120,000.
• Its payback period can be identified by calculating the cumulative cash flows over the four years,
as shown in the table below:

YEAR ANNUAL NET CASH FLOWS CUMULATIVE CASH FLOW $

0 (300,000) (300,000)
1 60,000
2 80,000
3 100,000
4 120,000

In which month will be paidback the initial investment?

PPI =

ARR = =

ACTIVITY # 6

• A business considers purchasing a new commercial photocopier at a cost of

$150,000. It expects the following revenue streams for the next five years:
$30,000, $50,000, $75,000, $90,000 and $100,000 respectivety.
• Calculate its ARR.

Solution:
 YEAR CASH FLOWS CUMULATIVE
0 (150,000) (150,000)
1 30,000
2 50,000
3 75,000
4 90,000
5 100,000

Total returns = $30,000 + $50,000 + $75,000 + $90,000 + $100,000 = $345,000

Capital cost = 150,000

PPI =

ARR =

ACTIVITY # 7
• The following table shows the expected cash flow from a business investment into
a fleet of new fuel-efficient vehicles.

Year Net cash flow ($)

0 (5 million)
1 2 million
2 2 million
3 2 million
4 3 million

• Calculate the average rate of return for the investment and payback period investment