3.3.2 - Investment Appraisal

What investment appraisal measures

When a business buys a new machine, opens a site or installs new technology, it commits a large sum of money now in the hope of receiving benefits later. That decision matters because the initial outlay ties up finance that could have been used elsewhere, so managers need a clear way to compare the cost of the project with the cash it is expected to generate.

In this topic, the starting point is the initial capital cost, which is the upfront spending on the investment, and the expected net cash flow from the project. Net cash flow means cash inflows minus cash outflows. If a project keeps generating positive net cash flow, it may eventually recover its cost and then add to the firm's overall returns.

Each technique answers a slightly different question, so exam answers improve when you are clear about what the method is actually measuring before you calculate it.

The key point is that these techniques do not all identify the "best" project in the same way. A fast payback improves liquidity, a high ARR suggests strong profitability, and a positive NPV suggests the investment adds value even after discounting future returns.

Simple payback

Simple payback focuses on speed. It measures how long it takes for the project to repay its initial investment. This is useful when cash is tight or when technology may become outdated quickly, because money recovered earlier can be used again sooner and the business is exposed to less risk over time.

To calculate payback, add the annual net cash flows cumulatively until the total reaches the initial outlay. If the business has not fully recovered the cost by the end of a year, divide the amount still to recover by the net cash flow in the next year to find the fraction of that year needed, assuming net cash flows accrue evenly within that year. If their timing is supplied, use that timing instead.

Suppose a manufacturer spends £120,000 on a new packaging machine.

By the end of year 3, the business has recovered £105,000, so £15,000 is still missing. In year 4, the project generates £25,000, so the remaining fraction is 15,000 / 25,000 = 0.6 of a year. That is about 7.2 months, so the payback period is about 3 years 7 months.

The usual decision rule is simple: the shorter the payback, the more attractive the project. Because cash returns sooner, the business improves liquidity earlier and reduces the danger of being stuck in a project for too long if conditions change.

Payback does, however, miss an important point: it ignores cash flows after the payback point. A project that pays back in 2 years but then earns little afterwards could be chosen over a project that pays back in 3 years and then generates much larger long-term returns.

Average rate of return

Average rate of return shifts the focus from speed to profitability. Instead of asking how quickly cash comes back, it asks how much net return the project earns each year as a percentage of the initial spending. That makes it useful when managers want a clear profitability percentage that can be compared with alternative investments or target returns.

Using ARR usually involves three steps:

1. Add the total net cash flow from the project.
2. Subtract the initial investment to find the total net return.
3. Divide by the number of years to find the annual average, then express that as a percentage of the original outlay.

Suppose a project costs £200,000 and is expected to generate net cash flows of £80,000, £70,000, £60,000 and £50,000 over four years. Total net cash flow is £260,000. Subtracting the initial cost leaves a total net return of £60,000. Dividing by four gives a net return per annum of £15,000. The ARR is therefore:

(15,000 / 200,000) × 100 = 7.5%

That figure means the project is expected to earn an average annual return equal to 7.5% of the original investment. If another project offered 5%, this one would usually look more attractive on ARR grounds because it appears to use the capital more profitably.

ARR is helpful because it gives a percentage that is easy to compare. However, it still has a major weakness: it ignores the time value of money. A return received in year 1 is treated the same as a return received in year 4, even though the earlier cash could have been reinvested sooner.