The process of analysing whether investment projects are worthwhile.

Annual Average Rate of Return (ARR)

  • The annual percentage return on an investment project based on average returns earned by the project

Calculating and interpreting ARR

  • Calculate the average annual profit from the investment project
  • Divide the average annual profit by the initial investment outlay
  • Compare with the target percentage return

Discounted Cash Flow (NPV)

Net present value (NPV) calculates the monetary value now of a project’s future cash flows.

  • Discounting is the method used to reduce the future value of cash flows to reflect the risk of inflation or the investment not working out.

The Time Value of Money

  • Better to receive cash now than in the future
  • Future cash flows are worth less
  • Use discount factors to bring cash flows back to their present value
  • Relevant discount factor determined by required rate of return

Calculating the present value of a future cashflow


Cash Flow x Discount Factor = Present Value

If NPV is positive, then the investment is worth doing. If NPV is negative, then the investment is not worth doing.

If you have a choice between two positive NPV projects, then you want the one with the highest NPV.

Payback Period

  • Identify the net cash flows for each period (eg, a year)
  • Keep a running total of the cash flows
    • Initial investment is an outflow
    • When does the running total move from negative to positive (outflows)
    • When the total net cash flow becomes positive, that is the end of the payback period.
YearCash Flow DetailCash flow £Cumulative Cash FlowPayback?
0Investment (cash out)(500,000)(500,000)No
1Net Cash Inflows100,000(400,000)No
2Net Cash Inflows150,000(250,000)No
3Net Cash Inflows175,000(75,000)No
4Net Cash Inflows150,00075,000Yes

In this case, there is an overshoot. It took 3 and a bit years to reach payback. We can tell because there is more than 0 at the end of year 4.


Payback Period = Initial Investment / Annual Cash Flow

Benefits of payback period

  • Simple and easy to calculate
  • Focus on cashflows
  • Easy to understand the results
  • Emphasises speed of return; good for fast moving markets
  • Straightforward to compare competing products

Drawbacks of payback period

  • Ignores cash flows after payback has been reached
  • Takes no account of the “time value of money”
  • May encourage short-term thinking
  • Ignores qualitative aspects
  • Does not actually create a decision for the investment.

Calculating and Interpreting ARR

  • Calculate the total net inflow from the project
  • Deduct the outlay (initial investment) to get the annual profit
  • Divide the total annual profit by the total number of years to get the average annual profit
  • Divide the average annual profit by the initial investment (“outlay”)
  • Compare with the target percentage return