Unit 5.6 — Investment appraisal
Learning outcomes (from the 9587 syllabus). This note is complete when every bullet below is covered.
Learning outcomes
- Capital investment appraisal: importance; relevant risk in investment decisions
- Investment appraisal techniques (meaning, calculation and interpretation): Payback; Average Rate of Return (ARR); Net Present Value (NPV)
Running example: Swift Logistics is deciding whether to spend $200,000 on a new automated sorting machine.
Big picture
In plain English: investment appraisal is working out whether a big spending project is worth it — how fast it pays back, how much profit it earns, and whether it is worth more than the money put in.
Analogy: appraising an investment is like deciding whether to buy an expensive machine for your business — how long until it pays for itself (payback), how much profit it makes each year (ARR), and is the future profit worth more than the cost today (NPV)?
Core content
1. Capital investment appraisal
Importance: capital is limited and investment projects are expensive and risky, so a business must choose the projects that give the best returns.
Relevant risk: a project’s future returns are uncertain — demand may fall, costs may rise, or technology may change — so appraisal must consider risk, not just the numbers.
2. The three techniques
Payback = the time taken to recover the initial investment from net cash inflows.
- Rule: the shorter the payback, the better (faster recovery = less risk).
- Strengths: simple; focuses on risk and liquidity.
- Weakness: ignores cash flows after payback.
Swift’s $200,000 machine generates $50,000 a year. Payback = 200,000 ÷ 50,000 = 4 years. If another machine pays back in 3 years, it is preferred on risk grounds — even if the 4-year machine earns more later (which payback ignores).
ARR (Average Rate of Return) = (average annual profit ÷ average investment) × 100.
- Rule: the higher the ARR, the better; compare with a target rate.
- Strengths: shows profitability as a %; easy to compare.
- Weakness: ignores the timing of returns (a dollar today ≠ a dollar in year 5).
Swift’s machine earns an average annual profit of $20,000 on an average investment of $100,000. ARR = (20,000 ÷ 100,000) × 100 = 20%. If Swift’s target is 15%, the project is worthwhile.
NPV (Net Present Value) = present value of future cash flows − initial investment.
- Rule: accept if NPV is positive (the project adds value).
- Strength: accounts for the time value of money (future money is discounted).
- Weakness: more complex; depends on the discount rate chosen.
Using a 10% discount rate, the present value of the machine’s future cash flows is $230,000. NPV = 230,000 − 200,000 = +$30,000. A positive NPV means the machine earns more than the 10% required return, so Swift should invest.
Analysis & evaluation points (AO3/AO4)
- No single technique is complete — payback ignores later returns, ARR ignores timing, NPV needs a discount rate. Use them together.
- Numbers are not enough — qualitative factors (reliability, staff training, brand, risk) also matter.
- The discount rate is a judgement — a wrong rate changes the NPV decision.
- Riskier projects should require higher returns — a risky project needs a bigger safety margin.
Language bank: however · on balance · it depends on · trade-off ·
Worked examples (PEEL)
PEEL = Point → Explain → Example → Link. Use this structure for every written answer. For calculations, always show the formula first.
Worked example 1 — “Calculate” (6 marks)
Question: A project costs $300,000 and earns $75,000 a year. Calculate the payback period.
- Formula: Payback = Initial investment ÷ Annual net cash inflow
- Substitute: = 300,000 ÷ 75,000
- Answer: = 4 years
- Interpret: The business recovers its $300,000 in 4 years; after that the project earns pure return.
Worked example 2 — “Evaluate” (12 marks)
Question: Evaluate the usefulness of the payback method of investment appraisal.
- P (Point): Payback is simple and focuses on risk.
- E (Explain): It is easy to calculate and understand, and it highlights how long money is at risk — a shorter payback means lower risk.
- E (Example): Swift prefers a machine that pays back in 3 years over one that pays back in 6, because the money is at risk for less time.
- L (Link): This helps cautious businesses manage risk and liquidity.
- Evaluate (AO4): However, payback ignores returns after the payback period and the time value of money, so it can reject profitable long-term projects. On balance, payback is a useful first screen for risk, but should be used alongside ARR and NPV for a full decision.
Application bank (Singapore quick reference)
| Idea | Singapore example |
|---|---|
| Investment appraisal | Firms appraising new machinery, IT systems or outlets |
| Payback thinking | SMEs favouring equipment that pays back quickly |
| NPV | Large firms (property developers) using discounted cash flow |
| Risk | Changi Airport projects appraising long-term, high-cost investments |
Exam technique
- How it appears: a case study gives project cash-flow figures and asks you to calculate payback, ARR or NPV, or to recommend between projects.
- Model skeleton for “recommend a project”: calculate the techniques → compare the projects → weigh qualitative factors → recommend one and justify.
- Common pitfalls: arithmetic errors (especially NPV discounting); choosing on one technique alone; ignoring qualitative factors.
Self-test checklist
Essay practice: “Evaluate the view that NPV is the best method of investment appraisal.” (25 marks)