Investment appraisal refers to the analysis done to determine the profitability of a particular project.
For example, if a company wants to decide whether or not it should invest in the extension of its premises, it can perform an investment appraisal to calculate the profitability of the investment.
Accountants use many investment appraisal techniques for this purpose. The technique that is easiest to calculate is the payback period.
The payback period is the amount of time (expressed in the number of days, months or years) it takes to recover the investment’s initial outlay. In other words, it is the amount of time it takes for the project to break even.
For example, if the said company invested $80,000 into an extension of its premises and takes them five years to get back that $80,000, the payback period is 5 years. As you recover your money faster, investments with lower payback periods are preferred to those with higher payback periods.
The simple way to calculate the payback period is by dividing the investment cost by the annual cash flow. However, there is a more accurate (and slightly more complicated) way of calculating this as well:
A + ((Cost of investment – B)/C) * 365 days/52 weeks/12 months, where
- A is the year for which the cumulative net cash flow is closest to the cost of investment
- B is the cumulative net cash flow during year A
- C is the net cash flow (note: not cumulative net cash flow) during the next year
The advantage of the payback method is that it’s simple to calculate and allows you to get a good idea of how profitable your investment is.
The problem with it is that it disregards the time value of money (TVM). As a result of inflation, $5 today is not equal to $5 next year: it is more valuable in the present day. This must be accounted for when calculating the figures for the net cash flows. Otherwise, the payback period would be inaccurate.