INVESTMENT APPRAISAL

• Is a process of evaluating whether it is worthwhile to invest funds in a project.

• It is important to carry investment appraisal because large sums of money are involved.

FOUR METHODS USED

SIMPLE METHODS/ NON (DCF) METHODS
1. Accounting Rate of Return
2. Payback Period
DISCOUNTED CASHFLOW METHODS
3. Net Present Value
4. Internal Rate of Return

NB. Accounting Rate of Return is based on profits where as Payback Period, NPV and IRR are based
on cashflows.

1. ACCOUNTING RATE OF RETURN

• This is the average profit (after depreciation) expressed as a percentage of average capital
invested.

ARR= Average profit/Average capital ×100

Average profit= Total profit/Number of years

Or Average Profit = (Total cashflows-Initial outlay)/number of years

Average capital=Initial outlay/2

Or Average capital=Initial Outlay /2 + working capital

A project with high ARR is the best

2. PAYBACK PERIOD
• It measures the time taken by an investment’s future cashflows to recover the initial outlay
• It is based on cashflows not profits.
• A project with a shorter payback is the best.

3. NET PRESENT VALUE

• Refers to the difference between the total discounted cashflows and the initial outlay.
 • NPV considers the time value of money since a dollar received today worths more than a
dollar received tomorrow because of loss of investment and inflation.
• The discounting rate used is the cost of capital
• A project with a high NPV is the best
NB A project with a Negative NPV is rejected as the future discounted cashflows will not cover
the initial outlay.

4. INTERNAL RATE OF RETURN

• This the rate of return that gives a NPV of zero if discounted to cashflows.
• The IRR represents the maximum a firm is willing to pay for finance.
• The IRR is accepted if it is above the cost of capital and the project with high IRR is the best.

(𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝐷𝐹× 𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑁𝑃𝑉)

IRR (%) = 𝑙𝑜𝑤𝑒𝑟 𝐷𝐹 =
𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑁𝑃𝑉+𝑁𝑒𝑔𝑎𝑡𝑖𝑣𝑒 𝑁𝑃𝑉