Investment appraisal techniques are used to evaluate investment options and determine their financial feasibility. The main techniques include payback period, average rate of return (ARR), and discounted cash flow analysis using net present value (NPV). Payback period calculates how long it will take to recoup the initial costs while ARR determines profitability. NPV discounts future cash flows to determine the present value of an investment while accounting for factors like risk, inflation, and opportunity costs. Both financial and qualitative factors must be considered in investment decision making.

1. Investment Decision-making
Ilona Kriauzaite, 2010

2. Content
Investment
Issues with investment appraisal
Investment appraisal techniques:
Payback
Average Rate of Return (ARR)
Discounted cash flow (NPV)
Qualitative factors affecting decisions:

3. Investment
Investment refers to the purchasing of
productive capacity or capital expenditure
Capital expenditure – Spending by a
business to buy fixed assets e.g. property,
vehicles etc

4. Why invest?
Businesses need to invest to grown
They might want to increase capacity so they
can produce more
If they produce more then they can sell more
and increase sales revenue
They could also look to invest to increase the
efficiency of their operations

5. Investment Appraisal
Looks at whether an investment project is
worthwhile or not
Can be used for all types of investment
from the purchase of a new piece of
machinery to a whole factory
It allows managers to make an informed
choice regarding the viability of the
project

6. Financial techniques of
investment appraisal
These are all based on a number of
assumptions:
All costs and revenues can be forecast
accurately for future years
Key variables like interest rates will not alter
That the business will be looking to maximise
profits

7. Problems with Forecasts
There may be problems with forecasts
because:
Competitors could bring out new products /
change prices altering sales and revenue
Tastes and fashions may change causing an
unexpected slump in demand
The economy may change either upwardly or
downwardly – recession or boom
Costs can be affected by inflation and import
prices

8. Investment Appraisal
Types of investment appraisal:
Payback Period
Accounting Rate of Return (ARR)
Net Present Value (discounted cash flow)
Discounted cash flow

9. Investment Appraisal
The idea is that if you invest in the future
you will have more incomes coming into
the business
Investment appraisal methods look at the
comparison of the future incomes with
the cost of the initial investment

10. Payback Method
This looks at how long it takes to pay
back the initial cost of the investment
Need to know how much revenue the
asset will generate
For example if a machine costs £50,000
and it produces items 50,000 items that
retail for 50p each it will take 2 years to
payback the initial investment

11. Payback method
This allows you to compare projects –
which one takes the shortest time to
payback the initial investment
It can take an investment less than a
year to generate revenues that cover its
cost

12. Advantages and
Disadvantages of Payback
Advantages Disadvantages
Easy and simple to Doesn’t look at
use and timings of
understand payments
Good if you just Doesn’t look at
want a quick rate of incomes received
return after payback
Profit isn't
calculated

13. Average Rate of Return
Looks at the profit generated by the
investment compared to the cost of the
investment
Average profit
ARR = ----------------------------------------
---- x 100
Initial cost of investment
This gives the business a % figure
showing the average rate of return
Businesses can then compare this figure
to how much they would get with
alternative investments / the bank

14. Advantages and
Disadvantages of ARR
Advantages Disadvantages
Looks at profits Only looks at
Easy to compare average profits
with other methods Doesn’t look at
of investment e.g. timings of
putting money in payments
the bank

15. Discounted cash flow
This considers what money will be worth
in the future
Discounting – reduce value of future
earnings to reflect opportunity cost of an
investment
Reasons why this exists:
Risk
Opportunity cost

16. Net Present Value
One way of discounting cash flow is looking at
NPV
This method takes into account inflationary
pressures and interest rates
The idea that the money increases in value
Looks at how much you would need to invest
now to earn a certain amount in the future
Allows comparison of an investment by valuing
all cash inflows from the investment at the
present value
You can compare what would happen if you
invested the money in other projects or just
saved it in the bank

17. Net Present Value
Future Value
PV = -----------------
(1 + i)n
Where i = interest rate
n = number of years
Cash flow x discount factor = present value
Present Values can be found through valuation
tables

18. Discounted cash flow –
Advantages and Disadvantages
Advantages Disadvantages
Looks at the Can be difficult to
opportunity cost of choose the right
investing discount rate
Considers cash Is very complex
inflows and
outflows for the
lifetime of the
investment

19. Qualitative techniques of
investment appraisal
As well as financial methods firms need
to consider:
Corporate image – you may reject an
investment opportunity as it will reflect badly
on your business
Corporate objectives – also have to judge if
the investment is aligned to your corporate
objectives
Environmental and ethical reasons – is the
investment environmentally and ethically
sound
Industrial relations – what is the impact on the
work force – does it decrease jobs?

20. Summary
Investment is the process of purchasing fixed assets in
order to increase capacity / productivity
Investment appraisal techniques aim to assess the
financial feasibility of investment options
Investment appraisal techniques are based on a number
of assumptions which may not be true
Payback method looks at how long it will take to pay back
the cost of the initial investment
Average rate of return looks at the percentage rate of
return on the investment
Discounted cash flow (NPV) looks at the present values of
any future revenues from the investment
Qualitative factors affect investment decisions including
corporate image, objectives, industrial relations and
environmental and ethical reasons