3.

8 Investment Appraisal
Mtro. Ian M. Guillen Ortega
 Definition
• Investment appraisal refers to the quantitative techniques used in
evaluating the viability or attractiveness of an investment proposal.
• It assesses and justifies the capital expenditure allocated to a particular
project.
• It therefore aims to establish whether a particular business venture is
worth pursuing and whether it will be profitable.
• Also assist businesses in comparing different investment projects.
• There are three methods of investment appraisal
• Payback period.
• Average rate of return
• Net present value
 Payback period
• This method estimates the length of time required for an investment
project to pay back its initial cost outlay.
• It looks at how long a business takes to recover its principal
investments amount from its net cash flows.
• It can be calculated using the following formula:
Example
Example
Continue…
Results

The results in example one

As a general rule, the
and two can be compared
shorter payback period of
with the results from other
the project, the better it is
projects to help decision
for the investing business.
making.
Advantages
It is simple and fast to calculate
It is a useful method in rapidly
changing industries such as
technology
• It helps to estimate how fast the initial
investment will be recovered before
another machine, for example, can be
purchased
It helps firms with cash flow
projects because they can
choose their investment projects
that can pay back more quickly
than others.

Since it is a short-term measure

Business managers can easily
of quick returns on investments,
understand and use the results
it is less prone to inaccuracies
obtained
have long term forecasting.
Disadvantages

1 2 3
It does not consider the cash It ignores the overall The annual cash flow could
earned after the payback. profitability of an be affected by unexpected
Which could influence investment project by external changes in demand,
major investment decisions. focusing only on how fast it which could negatively
will pay back. affect the payback period.
Average rate of return
• This method measures the annual net return on an investment as a
percentage of its capital cost.
• It assesses the profitability per annum generated by a project over a
period of time.
• It is also known as the accounting rate of return; it can be calculated
using the following formula:
Example
Results
The average rate of return
can also be compared with
banks interest rates on loans
to assess the level of risk.
Other businesses said
criterion rates were a
minimum rate that an
For example, in the above
investment project should
case, if banks offer an
not go below if it is to be
interest rate of 15%, the
selected, for example, if the
business may find it
criterion rate was set for
worthwhile to pursue
20% for the above
investment projects with a
businesses the average rate
return of 11% higher than
of return is 6% above the
the base lending rate.
rate and this will still be
considered a desirable
project to pursue
Advantages
It shows the profitability of an Unlike the payback period, it
investment project over a given makes use of all the cash flows in
period of time. a business.

A business can use its own

It allows for easy comparison with criterion rate and check this with
others competing projects for the average rate of return for a
allocation of investment funds. project to assess the viability of
the venture.
 Since it considers a longer time period or useful life of
the project, there are likely to be forecasting errors.
Long term forecast reduce the accuracy of the results.

It does not consider the timing of cash inflows. Two

projects might have the same average rate of return but
one could pay back more quickly compared to other
due to faster cash inflows.

The effects on the time value of money are not

considered.

Disadvantages