3.8 Investment appraisal

What we will study?

By the end of this unit you should be able to:

- Understand what investment means, why appraising investment projects is essential and the information needed for investment appraisal
- Assess why forecasting future cash flows adds uncertainty to investment appraisal
- Apply and analyse the payback method of investment appraisal
- Apply and analyse the average rate of return method of investment appraisal

What is the point of an investment appraisal?

In essence, we will be looking at the question 'is it worth investing in that project?'

Just like individuals, the finance available to firms is limited and so they must choose how to spend this finance in a way that offers the best return on their investment. This is not always an easy assessment because it is dependent upon the time period involved and the level of risk the firm is prepared to take.

A business may have a variety of investment decisions. They may have to choose between:

Launching one product or another
Between different locations for parts or whole of their business
Buying one piece of equipment or another

Investment appraisal is a quantitative technique used to avoid relying on 'hunch' decision making. However, like all such business tools it must be remembered that the reliability of the outcome is only as good as the data used in the appraisal.

Investment decisions for businesses involve capital expenditure, expenditure which should generate a return on that investment.

Quantitative investment appraisal

Quantitative investment appraisal refers to judging whether an investment project is worthwhile through numerical (financial) means.
Information needed to be able to undertake a quantitative investment appraisal includes:

1. Initial capital costs of the investment
2. Estimated life expectancy
3. The expected residual value (additional net returns from the sale of the asset at the end of its useful life)
4. Forecasted net returns or net cash flows from the project (expected returns less running costs)