Investment AppraisalExplained & Defined with Examples and Formulas

Written By:
Lisa Borga

Investment appraisal, also known as capital budgeting, is the way in which businesses and investors assess whether or not a particular investment will offer suitable returns.

This can be used when investing in a particular project, new equipment, new product lines, or stock investments, among others.

There are numerous techniques used by businesses and investors to appraise potential investments, and professionals will often utilize discounted cash flow techniques to account for the time value of money to ensure accurate results that reflect the long-term potential of an investment.

In addition, non-discounted methods may be used for reduced complexity and situations in which future estimates of cash flow are difficult to estimate.

Using multiple methods of investment appraisal is key to receiving the most accurate valuation of a potential investment, creating a successful investment portfolio, and maximizing the return from investing scarce resources.

Understanding Investment Appraisal

Investment appraisal provides input to assist in making investment decisions.

This appraisal provides users with information to judge whether or not a particular investment in a project, portfolio, or equipment would be justified.

This assists with making rational decisions that will benefit the organization or investor and optimize the use of scarce resources by making the investments that will provide the best return.

This is a crucial element of ensuring that an investment will optimize shareholder value or match an investor’s goals.

This is particularly crucial when an investment will require a significant amount of capital.

All investments entail some amount of risk, and when a particular investment requires a significant amount of inputs, an investment appraisal should include both considerations of quantitative and qualitative aspects of the investment.

In addition to legal considerations and the environmental and social impacts, an investment decision should consider the following elements.

• Affordability: Can the investment’s costs be afforded when considering it in terms of the wider portfolio of operations and investment activities?
• Return on Investment: Taking into consideration the cost of inputs, will the investment provide a suitable return, and is there a more beneficial alternative for the investment of these funds?
• The Wider Portfolio: Will the potential investment complement the existing range of investments in the organization or investor’s portfolio?

Some key inputs used to perform an investment appraisal include projections of expected cash flows, the costs of the investment, and the discount rate.

Investment Appraisal Methods

There are two primary categories of investment appraisal methods, and these are discounted and non-discounted methods.

The most prevalent discounted methods of investment appraisal include net present value, discounted payback period, internal rate of return, and profitability index.

The most commonly used non-discounted methods are the accounting rate of return and payback period.

Discounted Methods

Net Present Value (NPV)

One of the most commonly used investment appraisal techniques is NPV which provides an estimation of what the value of the expected revenue from an investment would be worth today.

By accounting for the time value of money, NPV provides an indication of whether or not future cash flows are able to cover the costs of an investment.

NPV is calculated by arriving at a discount rate to reduce the value of projected future cash flows to find their value in terms of today’s money.

Once the discounted future cash flows are calculated, the initial cash investment is subtracted from this to determine if it would be a profitable investment.

The formula for this is:

NPV = Discounted Future Cash Inflows – Initial Investment Cost

Once the initial cash outlays have been subtracted from the discounted projections of cash inflows, the value of the investment can be determined.

A positive result indicates that the investment’s return would outweigh expenditures and may be worth pursuing.

A negative number indicates that future cash flows would not justify the cost of the initial investment.

Discounted Payback Period

The discounted payback period calculates the number of years that it would take for a particular investment to break even from an initial expenditure.

This method recognizes the time value of money and uses a discount rate to reduce future cash flows to their present value.

Discounted Payback Period = Period Before the Discounted Payback Period Occurs + (Cumulative Cash Flow in Period Preceding Recovery / Discounted Cash Flow in Period After Recovery)

By recognizing the time value of money, an investor or company can more accurately see when a particular investment is expected to break even.

This provides a crucial indicator for when a particular project or investment can be expected to begin returning profits.

Internal Rate of Return

The Internal Rate of Return for a project is the discount rate that will cause the net present value (NPV) of the project to be zero.

This will be the compound annual rate of return that is expected to be earned on the investment or project.

The formula for the internal rate of return is:

[{Cash Flows Year 1 / (1+IRR)^1} + {Cash Flows Year 2 / (1+IRR)^2} + {Cash Flows Year 3 / (1+IRR)^3} + {Cash Flows Year 4 / (1+IRR)^4}] – Initial investment = 0

Though this sounds confusing in simple terms, what it tells a company’s management is simply the percentage return that is required in order for an investment to break even while accounting for the time value of money.

Because this is what it would take to break even on the investment, it will mark the minimum acceptable return in order to move forward.

Profitability Index

The Profitability Index is a way of measuring the ratio between the present value of cash inflows and the present value of cash outflows.

This index is used by companies to rank potential investment projects and indicate the value they would receive for each unit of investment.

The Profitability Index is sometimes referred to as the Value Investment Ratio or the Profit Investment Ratio as well.

Non-Discounted Methods

Accounting Rate of Return

The accounting rate of return is a measurement of the annual net income that a particular investment will provide divided by its annual cost.

This metric provides a clear percentage result which can then be compared with a company’s minimum rate of return, or hurdle rate, in order to judge if the investment is worthwhile.

The formula for the accounting rate of return is:

Accounting Rate of Return = Average Annual Return / Average Investment

This provides a simple metric to use when considering projects to pursue.

However, due to the lack of consideration of the time value of money or an investment’s cash flow, it is often not an optimal tool for appraising potential investments.

Payback Period

The payback period is the time period over which an investment’s initial cost will be recouped.

In other words, this is how long it will take for an investment’s returns to break even with its initial costs.

This is simpler to calculate than the discounted payback period because it does not require calculating a discount rate.

However, as a result, it is less accurate.

The formula for calculating the payback period is:

Payback Period = Investment Cost / Average Annual Cash Flow

This measurement provides a valuable indication of the period of time over which an investment will recoup its initial costs.

However, because this does not account for the time value of money, it provides a less accurate representation of the value of investments with a long holding time.

Investment Appraisal Example

As an example of investment, appraisal considers ABC Company which is looking to purchase new production equipment.

The ABC Company decides on two options.

Option one will cost the company $100,000 and generate revenues of $40,000, $35,000, $30,000, and $25,000 respectively over the course of four years.

Option two will also cost the company $100,000 and generate revenues of $60,000, $50,000, $20,000, and $10,000 respectively.

The ABC Company chooses to consider the payback period of the two options to see which will recoup its investment the quickest.

Because option two will recoup its investment in year two, while option one will only recoup it in year three, it chooses to invest in option two.

For a second example, consider an investor that is considering purchasing an investment that would cost $50,000 and provide returns of $20,000 over a period of five years.

The investor determines that a discount rate of 10% is appropriate and applies this to the returns over the five-year period.

Based on this calculation, the investor finds that the net present value of the investment is $75,815.74, which is significantly greater than the initial cost of $50,000.

As a result, the investor would make significant returns on the investment and should likely pursue it so long as no alternatives with a higher NPV are available.

Frequently Asked Questions

What Is the Meaning of Investment Appraisal?

Investment appraisal means evaluating an investment opportunity to judge whether or not it will offer suitable returns to the organization or investor.

This focuses primarily on the economic benefits that the investment may offer.

Why Is Investment Appraisal Important?

Investment appraisal is a crucial process for both companies and investors to analyze potential investment opportunities and provide valuable information to guide decisions on whether or not to pursue the investment or project.

Investment appraisal can offer the organization information such as the time until the investment will break even, potential benefits and risks, as well as the potential profits or losses.

Having clear quantitative information provided by investment analysis can greatly simplify decision-making.

Is There an Investment Appraisal Formula?

There are many techniques used to perform investment appraisal, and each has its own formulas associated with it.

These formulas may be significantly different such as the formula for NPV, which is NPV = Discounted Future Cash Inflows – Initial Investment Cost, and the formula for accounting rate of return, which is Accounting Rate of Return = Average Annual Return / Average Investment.

Depending upon the type of investment that is being appraised, the appropriate technique for appraisal and the associated formula may vary considerably.

Key Takeaways

• Investment appraisal is critical for both investors and businesses to decide whether or not a particular investment is worth pursuing or not.
• Investment appraisal methods may be used when making a variety of investment decisions, including whether or not to take on a new project, invest in a particular stock, purchase new machinery, and much more.
• There are two common categories of investment appraisal methods, including discounted methods and non-discounted methods.