3.8 Investment appraisal

Question 1

Average rate of return (ARR)

Answer 1

Theaverage rate ofreturn (ARR) calculates theaverage annual profit of an investment project, expressed as a percentage of the initial sum of money invested.

ARR =
(Total profit during project’s lifespan ($)
/ Number of years of project) /
Initial amount invested ($)

Question 2

Discounted cash flow

Answer 2

Discounted cash flow uses a discount factor (the inverse of compound interest) to reduce the value of money received in future years because money loses its value over time.

Question 3

Investment

Answer 3

Investment refers to the purchase of assets with the potential to yield future financial benefits, e.g.upgrading computer systems or the purchase of property (such as land and buildings).

Question 4

Investment appraisal

Answer 4

Investment appraisal is a financial decision-making tool that helps managers to calculate whethercertain investmentprojects should be undertaken based mainly on quantitative techniques.

Question 5

Net present value (NPV)

Answer 5

Net present value (NPV) calculates the total discounted net cash flows minus the initial cost of an investment project. If the NPV is positive, then the project is viable on financial grounds.

Question 6

Payback period (PBP)

Answer 6

The paybackperiod(PBP) is an investment appraisal technique that calculates the length of time needed to recoup (earn back) the initial expenditure on an investment project.

PBP =
Initial investment cost ($) /
Contribution per month ($)

Question 7

Qualitative investment appraisal

Answer 7

Qualitative investment appraisal refers to judging whether an investment project is worthwhile through non-numerical means, e.g. is the investment consistent with the corporate culture?

Question 8

Quantitative investment appraisal

Answer 8

Quantitative investment appraisal refers to judging whether an investment project is worthwhile based on numerical (financial) interpretations, i.e. the PBP, ARR and NPV.