When a business is deciding whether to spend money on something big — a new machine, a second location, a product launch — they need a way to work out if it's actually worth it. Investment appraisal is the set of techniques they use to answer that question.
There are three main methods, each answering a slightly different question:
The exam will often give you data and ask you to calculate one of these, then evaluate whether the investment should go ahead. Remember: no single method gives the full picture. A strong answer uses more than one method and discusses their limitations.
The time it takes for an investment to generate enough cash flow to cover its initial cost. Shorter = less risky.
Enter the initial investment and annual cash flows. Add or remove years as needed.
Strengths: Simple to calculate and understand. Useful for businesses with cash flow concerns — tells you when you'll get your money back. Good for comparing projects when speed of return matters.
Weaknesses: Ignores all cash flows after payback. Ignores the time value of money (£1 in year 5 is treated the same as £1 in year 1). A project with a short payback but low total returns might be chosen over a more profitable long-term project.
Calculates the average annual profit as a percentage of the investment. Allows comparison against interest rates or other investments.
Enter the initial cost and annual cash flows (net returns, not profit — the calculator works out the profit for you).
Strengths: Gives a percentage that's easy to compare against bank interest or other investments. Considers all cash flows over the project's lifetime, not just until payback.
Weaknesses: Still ignores the time value of money. Uses averages, which can hide big variations between years. A project where most money comes early looks the same as one where it comes late.
The most sophisticated method. It adjusts all future cash flows to their present value (what they're worth today) using a discount rate, then subtracts the initial cost.
Each year's cash flow is multiplied by a discount factor to convert it to today's value. The further in the future, the smaller the factor.
The discount factor formula is: 1 ÷ (1 + r)ⁿ where r = discount rate and n = year number.
| Year | 5% | 8% | 10% | 12% | 15% |
|---|---|---|---|---|---|
| 0 (Now) | 1.000 | 1.000 | 1.000 | 1.000 | 1.000 |
| 1 | 0.952 | 0.926 | 0.909 | 0.893 | 0.870 |
| 2 | 0.907 | 0.857 | 0.826 | 0.797 | 0.756 |
| 3 | 0.864 | 0.794 | 0.751 | 0.712 | 0.658 |
| 4 | 0.823 | 0.735 | 0.683 | 0.636 | 0.572 |
| 5 | 0.784 | 0.681 | 0.621 | 0.567 | 0.497 |
In the exam, the discount factors are given to you in a table — you don't need to calculate them. Just multiply.
Enter the initial investment, discount rate, and annual cash flows.
Strengths: The only method that accounts for the time value of money. Considered the most reliable method by financial theory. Gives a clear yes/no answer: positive NPV = invest, negative = don't.
Weaknesses: More complex to calculate. The result depends heavily on the discount rate chosen — and this is a prediction that might be wrong. Assumes cash flows are certain, which they never are.
The same investment analysed three ways. Use the default figures or calculate your own in each tab first, then come back here.
| Method | Question It Answers | Time Value? | Complexity | Best For |
|---|---|---|---|---|
| Payback | How long until I get my money back? | No | Simple | Cash-poor businesses, risky markets |
| ARR | What % return do I earn per year? | No | Simple | Comparing against bank interest or other projects |
| NPV | Is this worth more than it costs in today's money? | Yes | Complex | Large, long-term investments |
Two investments might give conflicting results across methods. For example:
Project A: Payback in 2 years, ARR of 12%, NPV of £5,000
Project B: Payback in 4 years, ARR of 18%, NPV of £15,000
Project A wins on payback (faster return), but Project B wins on ARR (higher percentage) and NPV (more valuable overall). Which should you choose?
Investment appraisal gives you numbers, but the final decision also considers:
Risk and uncertainty — How confident are the cash flow predictions? A new market is riskier than expanding an existing one.
Corporate objectives — Does the investment align with the business's strategy? A green energy project might have a lower NPV but fits a sustainability objective.
Stakeholder impact — Will the investment affect employees, suppliers, or the local community? A factory relocation might save money but lose experienced staff.
Opportunity cost — What else could the money be spent on? Even a positive NPV project might not be the best use of limited funds.
Point: State which method you're using and what the result shows.
Evidence: Show the calculation or reference the data.
Explain: What does this mean for the business? Build a consequence chain.
Link back: Connect to the specific business context in the question.
Evaluate: Discuss limitations of the method used, consider non-financial factors, and come to a justified conclusion.