What investment appraisal is

The decision these methods are for

• Investment appraisal is a set of methods for deciding whether a large, long-lived purchase is worth making — and which of two options is better.
• The purchases it applies to are capital purchases: machinery, vehicles, buildings, a new production line, a software system. They share three features:
  • a large amount of money paid out at the start
  • returns spread over several years
  • the money is hard to get back once spent
• The standard names three methods: payback period, average (accounting) rate of return and net present value. You need all three, and you need to know what each one misses.

The three questions the methods answer

Method	The question it answers	What it measures
Payback period	How long until we get our money back?	Risk and cash flow
Accounting rate of return	What percentage return does it earn?	Profitability
Net present value	Is it worth more than it costs, in today's money?	Value, allowing for time

• They do not always agree, and the exam likes it when they do not. When two methods point different ways, the answer is not "one is right" — it is that the business must decide which question matters most to it right now.

The information you are given

• Every appraisal starts from the same inputs:
  • Initial cost — the total cash paid out at the start, including installation and training.
  • Net cash flows — the cash the investment brings in each year, after the running costs of the investment itself.
  • The life of the investment — how many years it will produce those flows.
  • The discount rate (for net present value) — the return the business could get elsewhere, or the cost of its borrowing.
• Net cash flow is not profit. Cash flow is money in minus money out. Profit subtracts depreciation, which is not a cash payment. For Level 3 you use the figures the question gives and label them the way the question labels them.

A worked set of figures used across the next three pages

• These figures are invented and illustrative. They are used on all three method pages so you can see the same investment judged three different ways.
• Kōwhai Coast Packaging (invented) is a Tauranga exporter considering a new labelling machine:

Initial cost	$180,000
Net cash inflow, year 1	$60,000
Net cash inflow, year 2	$70,000
Net cash inflow, year 3	$80,000
Net cash inflow, year 4	$80,000
Life	4 years
Discount rate	10%