Investment appraisal
Payback and ARR
- Investment appraisal asks whether a big spending project is worth it.
- Payback period — the time for the project's cash inflows to repay the initial cost (shorter = safer).
- Accounting rate of return (ARR) — average yearly profit as a % of the money invested:
$$\text{ARR} = \frac{\text{average annual profit}}{\text{initial investment}} \times 100\%$$
Practice
The payback period is the time for:
Payback is how long the project's inflows take to repay the initial outlay; shorter is safer.
Practice
A project has average annual profit of 5,000 from a 25,000 investment. What is the ARR (%)?
ARR = average annual profit ÷ initial investment × 100% = 5,000 ÷ 25,000 × 100% = 20%.
Net present value
- Net present value (NPV) recognises that future money is worth less than money today.
- It uses discounting to shrink future cash flows to today's value, then subtracts the initial cost.
- A positive NPV means the project adds value.
Practice
A positive net present value (NPV) means the project:
NPV discounts future cash to today's value; positive NPV means the project adds value.
You've got it
Key idea
- payback = time to repay the cost (shorter = safer); ARR = average annual profit ÷ initial investment × 100%
- NPV discounts future cash flows to today's value; positive NPV = adds value
- payback is simple, ARR shows profitability, NPV is most complete (needs a discount rate)