Investment Appraisal
- Every investment a business makes, whether buying new equipment, launching a product, or expanding operations, comes with costs, risks, and expected returns.
- Investment appraisal helps businesses decide if an investment is worth it by using financial techniques to measure profitability and risk.
Investment Appraisal
Investment appraisal is the process of evaluating the potential profitability and risks of an investment to determine its financial viability.
Key Methods of Investment Appraisal
- Payback Period: Measures how long it takes for an investment to recover its initial cost from cash inflows.
- Accounting Rate of Return (ARR): Evaluates profitability by comparing average annual profit to initial investment.
- Net Present Value (NPV): Calculates the present value of future cash flows, considering the time value of money.
Payback Period: How Long Until You Break Even?
Payback Period
The payback period is the amount of time it takes for an investment to generate enough cash flows to recover the initial investment cost.
- As a business owner considering investing in something new, you need to know:
- How long it will take to recover your investment.
Investment appraisal helps businesses make informed decisions by evaluating the financial viability of projects.
How to Calculate the Payback Period
- Cumulative Cash Flow Method:
- Track cash inflows year by year.
- Identify when cumulative cash inflows equal the initial investment.
- Formula for Partial Years:
$$\text{Payback Period} = \text{Number of full years} + \frac{\text{Amount still needed}}{\text{Cash inflow in next year}}$$
Step-by-Step Calculation For Cumulative Cash Flow Method
Consider a business that invested $400,000 in the project.
| Year | Cash Inflow ($) | Cumulative Cash Flow ($) |
|---|---|---|
| 1 | 100,000 | 100,000 |
| 2 | 100,000 | 200,000 |
| 3 | 200,000 | 400,000 |
| 4 | 300,000 | 700,000 |
Solution
- Initial Investment: The business invested $400,000 in the project.
- Cumulative Recovery: By the end of Year 3, the cumulative cash inflow reaches $400,000, meaning the investment is fully recovered at this point.
- Payback Period: Since the full investment is recovered exactly at the end of Year 3, the payback period is 3 years.
- If the initial investment were higher, say $450,000, the business would need an additional $50,000 from Year 4’s cash inflow.
- In that case, we’d calculate the extra months needed within Year 4.
Step-by-Step Calculation For Partial Years Method
Consider a business that invested $450,000 in the project and by the end of Year 3, it had recovered $400,000 through cumulative cash inflows.
| Year | Cash Inflow ($) | Cumulative Cash Flow ($) |
|---|---|---|
| 1 | 100,000 | 100,000 |
| 2 | 100,000 | 200,000 |
| 3 | 200,000 | 400,000 |
| 4 | 300,000 | 700,000 |
Solution
- Initial Investment: The business invested $450,000 in the project. By the end of Year 3, it had recovered $400,000 through cumulative cash inflows.
- Remaining Amount to Recover:
- At the end of Year 3, there is still $50,000 left to recover (\$450,000 - \$400,000).
- Calculating Partial-Year Payback:
- In Year 4, the total cash inflow is $300,000, meaning the business earns an average of $25,000 per month ($300,000 ÷ 12 months).
- To recover the remaining $50,000, the business needs: 50,000 ÷ 25,000 = 2 months
- Final Payback Period: The investment is fully recovered in 3 years and 2 months.
Pros and Cons of the Payback Period
| Advantages | Disadvantages |
|---|---|
| Simple and quick to calculate | Ignores cash flows after payback |
| Useful for businesses needing fast returns | Doesn’t measure total profitability |
| Helps firms with cash flow issues choose faster-paying investments | Doesn’t account for the time value of money |
Payback Period is best for businesses with liquidity concerns or rapidly changing industries where fast recovery is crucial.
Common Mistake- Don't assume a shorter payback period always means a better investment.
- It only shows how quickly the initial cost is recovered, not the total profit.
