10.3 Investment Appraisal – Investment Appraisal Decisions
What is Investment Appraisal? 📈
Investment appraisal is like a detective game for business owners. They look at future cash flows, compare them to the cost of the project, and decide if the project will bring more money than it costs.
Common Appraisal Methods
- Payback Period (PP) – How long until you get your money back? ⏱️
- Net Present Value (NPV) – Value of future cash flows today.
\$NPV = \sum{t=0}^{n} \frac{Ct}{(1+r)^t}\$ - Internal Rate of Return (IRR) – Discount rate that makes NPV zero.
\$NPV(r)=0\$ - Profitability Index (PI) – NPV divided by initial cost.
\$PI = \frac{NPV}{Initial\ Cost}\$ - Accounting Rate of Return (ARR) – Average accounting profit over cost. 📊
- Discounted Payback – Payback period using discounted cash flows. ⚖️
Comparison Table of Methods
| Method | Key Strength | Main Limitation |
|---|
| Payback Period | Simple & quick to calculate. | Ignores cash flows after payback & time value of money. |
| NPV | Considers all cash flows & time value. | Requires accurate discount rate & future cash estimates. |
| IRR | Shows rate of return, easy comparison with cost of capital. | Can give multiple rates if cash flows change sign. |
| PI | Useful when capital is limited. | Does not give absolute value, only relative. |
| ARR | Based on accounting figures, easy to compute. | Ignores cash flows & time value of money. |
| Discounted Payback | Adds time value to payback concept. | Still ignores cash flows after payback period. |
Analogy: Choosing a Plant for Your Garden 🌱
Imagine you want to plant a tree that will give fruit for many years.
- Payback Period: How many years until the tree starts giving fruit? Quick check.
- NPV: Total value of all future fruit, discounted for how much you’d like to have that fruit today.
- IRR: The “growth rate” of the tree’s fruit yield.
- PI: How many fruits you get per unit of seed you planted.
- ARR: Average profit from the tree’s fruit compared to the seed cost.
Just like a gardener chooses the best tree based on many factors, a business chooses the best investment method based on its goals.
Exam Tips for A-Level Business 9609
- Always state the discount rate used for NPV and IRR calculations.
- Show the formula for each method before plugging in numbers.
- Explain the main limitation of the chosen method in your answer.
- Use clear headings and bullet points to organise your answer.
- When comparing methods, summarise in a table or short list.
- Remember that NPV > 0 and IRR > cost of capital usually mean the project is acceptable.
- Practice converting between NPV and IRR for the same cash flow series.