05: Financial appraisal of investments

Financial analysis of projects normally involves complex computations using spreadsheets and adopting different appraisal methods for evaluating different potential investments. Two traditional non-discounting methods used are the accounting rate of return (ARR) – also referred to as the return on investment (ROI) – and the payback method.

ROI is determined by taking the total investment sum and working out the increased sales it will generate each year and the net profit from that, then calculating it as a percentage of the investment. Where several projects are under consideration, the one with the highest rate of return gets accepted.

The payback method concentrates on cash flows, not profits, and appraises projects in terms of which has the shortest payback period (for repaying the initial cost) in order to reduce the risks of unforeseen circumstances throwing up complications.

Both of the above methods, however, fail to fully account for the timing of the cash flows, and there are other techniques that take this into account.

Discounted cash flow, for example, provides a way of valuing an investment using the concept of the time value of money. This method enables you to determine the present value of future cash flows by discounting them using the appropriate cost of capital and taking account of the fact that cash flow in different time periods cannot be compared. This method is being viewed as increasingly important in helping to determine whether or not an investment project should be undertaken.