investment-appraisal-decisions

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Quantitative results and decision-making

When a business is deciding whether to invest in a project, the quantitative methods of payback period, average rate of return (ARR) and net present value (NPV) can help it to make an informed choice
They are likely to set specific investment criteria

Method	Explanation	Example
Payback period	A shorter payback period is usually preferred It means the business gets its money back faster	A firm may only accept investments with a payback period of less than 3 years
Average rate of return (ARR)	The investment’s return is compared to other possible uses of the money, such as placing it into an interest-paying account	A business might set a rule that projects must achieve at least 15% ARR to be approved
Net present value (NPV)	A positive NPV means an investment is financially worthwhile	A business may only accept projects with a positive NPV above $5,000 to ensure added value

Using quantitative methods to make investment decisions has a range of advantages
- It helps reduce risk by avoiding unprofitable investments
- It makes comparisons between different projects more objective and data-driven
- It enables managers to set clear and measurable targets for investment decisions
However, these methods focus on financial results
- Good decisions also consider non-financial factors like environmental impact, employee wellbeing or customer satisfaction

Non-financial factors can be just as important as quantitative analysis when making investment decisions

Qualitative factor	Explanation	Key question
Business aims and objectives	The investment should align with the business’s overall goals (e.g. growth, sustainability, social impact)	Does the investment support the business’s mission and long-term goals?
Stakeholder impact	Consider how the investment will affect employees, customers, suppliers, and the local community	Will it lead to job losses, new opportunities, or community disruption?
Environmental impact	Projects that harm the environment may damage reputation or go against ethical values, while green projects support sustainability	Will the project harm or protect the environment?
Risk tolerance	Some businesses are more willing to take risks depending on size, finances, and confidence in the market	Is the business willing and able to take on the level of risk involved?

Each of the methods of investment appraisal measures a different metric and is more appropriate in certain situations
Each method also has a range of limitations of which users should be aware when using the method to make investment decisions

Method	What it measures	When to use It	Key limitations
Payback period	The time it takes to recover the initial investment from cash inflows	When the business values speed of repayment and wants to reduce risk, especially in uncertain markets	It ignores total profitability and cash flows after payback It does not account for the time value of money
Average rate of return (ARR)	The average annual profit earned, expressed as a percentage of the investment	Useful for comparing profitability between multiple projects Simple for non-financial managers to understand	It ignores timing of cash flows and the time value of money It is based on accounting profit, not cash
Net present value (NPV)	The present value of future returns minus the initial investment, using a discount rate	Best for large or long-term investments where risk and time value of money need to be considered	It is more complex to calculate Results depend on the chosen discount rate It may be harder to explain to stakeholders