Investment Appraisal
Business Management: IB Diploma, topic 3.6.1
Investment Appraisal
Investment appraisal refers to the process of appraising or working out, whether an investment is likely to meet the business’ project objectives.
Use of investment appraisals
- Investment appraisal allows a business to work out whether an investment is profitable enough, or whether it pays back quickly enough.
- Investment appraisal also allows a business to compare one project with another project and decide which project is the most suitable for the business’ needs.
Risk of investment
- Investments carry risk for businesses as all investments require a financial commitment.
- Investments involve taking risks in the hope of a possible reward, or profit.
- Investment appraisal allows businesses to decide whether any potential return is worth the risk associated with an investment.
Information for investment appraisals
- Businesses need to gather as much information as possible about any investments they are considering.
- Investment appraisal includes three techniques which provide a business with different information about any potential investment:
- Net Present Value.
- Average Rate of Return.
- Payback.
Net Present Value
- Net Present Value is expressed using a real value in pounds and pence.
- A negative NPV suggests that a project will not make a business any money whereas a positive NPV suggests that a project will produce a return for the business.
Average Rate of Return
- Average Rate of Return is expressed as a percentage and is calculated using:
- (Average net return ÷ investment) × 100
- The higher the ARR percentage, the higher the project return in comparison to the original investment.
- The ARR can be used to compare the project with other projects, including investing the money in a bank account and accruing interest.
Payback
- Payback is expressed as a period of time. It is the amount of time for cash flow to be equal to the initial cost of a project.
- The shorter the payback, the quicker the business recovers its original investment.
- The payback period can be used to compare the project with other projects and businesses with liquidity concerns may choose a project with the quickest payback.
Test yourself on Investment Appraisal
Project 1 has an initial investment of £15,000,000. What is the net present value of the project if you ignore cash flows earned after Year 3?
If a business wants to maximise profit, all else being equal, which payback period will be most attractive for a business?