Investment appraisal — Edexcel A-Level Business
Test yourself on Investment appraisal with PEARSON EDEXCEL A-Level practice questions.
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Investment appraisal explained
This measure asks how long a project takes to return the cash it swallowed, answered in years and months rather than in profit.
Read the full explanation
Run down the cumulative net cash flow until the outlay is recovered, then take the amount still outstanding at the start of that year, divide it by that year's inflow and multiply by twelve to turn the fraction into months. Speed matters most where cash is tight, where borrowing is dear, or where equipment dates quickly, so a retailer refitting a store sets a cut-off period and rejects anything slower. The blind spot is everything after the recovery date. A machine that repays in two years and then breaks beats, on this measure alone, one that repays in three and earns for a decade, which is why the method belongs at the screening stage and not at the decision itself.
b) Average (Accounting) Rate of Return
This technique turns a project into a single percentage that can be set beside bank interest, the cost of borrowing, or the return on capital employed the business already earns. Total the net cash inflows over the project's life, subtract the initial outlay to get total profit, divide by the number of years to get average annual profit, then divide that by the initial outlay and multiply by one hundred. A result below the cost of capital destroys value however large the headline cash looks, while a result comfortably above it is only persuasive if the forecasts underneath are sound. What the percentage cannot see is timing. A project earning nothing until its final year scores exactly the same as one earning steadily from the start, and a single disastrous trading year disappears inside the average.
c) Discounted Cash Flow (Net Present Value only)
Discounting recognises that cash arriving in five years is worth less than the same cash today, because money in hand can be invested, inflation erodes it, and a distant promise carries more risk. Multiply each year's net cash inflow by the discount factor given in the table, add the present values together, then subtract the initial outlay, which is already in today's money and is therefore never discounted. A positive result means the project beats the return built into the rate chosen and adds value measured in pounds; a negative one means the money would do better elsewhere. The rate does the heavy lifting, since raising it punishes distant cash flows hardest, so a marginal long life project can be flipped from accept to reject by an assumption about the cost of capital that nobody in the case can prove.
d) Calculations and interpretations of figures generated by these techniques
Marks divide roughly in half on this kind of question: the arithmetic, presented with units and visible working, and the sentence that says what the number means for the business in front of you. The three methods can disagree, and that conflict is usually the question. One option may return its cash fastest while the other adds more value once discounted, so the recommendation turns on the firm's objectives, its cash position, how long the product is expected to sell and how much risk the owners can carry. Test the figures before trusting them, asking what happens if inflows fall by a tenth or the discount rate rises, and name the assumption the decision rests on. Then weigh the non-financial side, staff capacity, brand fit, ethics and likely competitor reaction, because a project can look right on the numbers and still be wrong for this firm.
e) Limitations of these techniques
Payback, average rate of return and net present value all compress a messy future into one tidy figure, and the weakness they share is that the figure is only as trustworthy as the forecast cash flows fed into it. Payback stops counting the moment the outlay is recovered, so it is blind to a large return arriving in year five; average rate of return is average annual profit over initial outlay as a percentage, so it uses accounting profit rather than cash and ignores when that profit lands; net present value rests on a discount rate somebody chose, and a two percentage point change in it can reverse the ranking of two projects. None of the three prices in staff morale, brand damage, ethical objections or competitor retaliation, which is why a recommendation has to weigh the number against the context.
Your focus
- a) Simple payback
- b) Average (Accounting) Rate of Return
- c) Discounted Cash Flow (Net Present Value only)
Show all 5 objectives
- d) Calculations and interpretations of figures generated by these techniques
- e) Limitations of these techniques
Investment appraisal exam tips
Marking Points
- Use net cash flow rather than profit, and treat the initial outlay as the amount to be recovered before any project gains anything.
- Show the cumulative column, identify the last year with a shortfall, then divide the remaining outlay by the next year's inflow and multiply by twelve for the months.
- State the answer with units, years and months, and compare it against the firm's cut-off period or against the rival project in the case.
- Explain why a short recovery period suits this business, linking it to liquidity, the cost of borrowing or the risk that the technology dates.
- Give the limitation with an example: cash arriving after the recovery date is ignored entirely, and so is the fact that early cash is worth more than late cash.
- Subtract the initial outlay from total inflows before averaging, since forgetting this step measures cash returned rather than profit earned.
- Divide by the correct number of years, which is the life of the project and not the number of figures shown in the table.
- Express the answer as a percentage, to one or two decimal places, and say what it is being compared against.
- Interpret against a benchmark in the case, such as the interest rate on the loan funding the project or the return the business currently makes.
- Evaluate the method itself, noting that it ignores when the cash arrives and that averaging conceals volatile or loss making years.
- Apply the correct factor from the correct column and year, showing each present value before totalling them.
- Leave the initial outlay undiscounted and subtract it from the total present value, then state the answer in pounds.
- Give the decision rule explicitly, that a positive figure means the project earns more than the required return and should be accepted on financial grounds.
- Explain why the discount rate was chosen, linking it to the interest on borrowing or the risk attached to this particular project.
- Evaluate sensitivity by saying what a higher rate or a shortfall in inflows would do to the result, and which assumption the decision hangs on.
- Present every calculation with units and stages visible, since method marks are awarded even when a figure is mistyped.
- State the decision rule attached to each result, the cut-off period for recovery, the cost of capital for the percentage return, and a positive figure for the discounted total.
- Recognise and explain conflict between the measures rather than quoting whichever one supports the answer already chosen.
- Run a sensitivity comment, saying how far inflows could fall before the recommendation changes, and identify the weakest assumption in the forecast.
- Recommend one option and justify it against a stated criterion drawn from the case, such as a loan repayment schedule or a strategic objective.
- Bring in non-financial factors, including staff, customers, ethics and competitor response, and say how heavily each should weigh.
- Naming the specific weakness of the specific technique used in the case, such as payback ignoring every inflow after the cut off point, rather than a general remark that forecasts can be wrong.
- Linking the weakness to the data in the extract, for example showing that the project with the shorter payback has the lower net present value, so the ranking depends on which technique the board trusts.
- Explaining that net present value moves inversely with the discount rate, so a rise in interest rates shrinks every discounted inflow and can turn a positive figure negative.
- Bringing in the qualitative factors appraisal cannot price, such as reputational risk or the skills of the workforce, and saying why they matter to this business.
Examiner Tips
- 💡Calculation marks are commonly two to four with method credited separately, so lay out the cumulative cash flow even under time pressure.
- 💡The follow-up is usually assess or recommend, so be ready to say why liquidity or obsolescence makes speed the right criterion for this particular firm.
- 💡Never present this measure alone in an evaluation; pair it with the return percentage or the discounted figure and explain what each adds.
- 💡The arithmetic is worth three or four marks, and method marks survive an arithmetic slip, so write each stage on its own line.
- 💡Examiners reward a comparison against the cost of borrowing quoted in the extract, so look for an interest rate before you comment on the result.
- 💡In a longer answer, use this figure for profitability and the recovery period for risk, then explain which the business should weight more heavily.
- 💡Discount factors are always supplied, so never try to work them out; the marks are for applying them, totalling and subtracting correctly.
- 💡Set the working out as a small table with year, cash flow, factor and present value, because method marks are awarded line by line.
- 💡For an evaluate question, comment on the size of the figure relative to the outlay, since a small positive result on a large investment is a thin margin for error.
- 💡Longer questions often supply a table of cash flows and a set of discount factors, so budget time to calculate first and leave the majority of the space for judgement.
- 💡Quantify wherever the data allow, because an evaluation that uses the firm's own figures consistently outscores one written in general terms.
- 💡Finish with a conditional conclusion, naming what would have to change for the opposite recommendation to become the right one.
- 💡This is nearly always asked straight after a calculation, so quote your own payback period or net present value as evidence instead of starting a fresh argument.
- 💡Assess and evaluate questions on this topic carry the highest tariff, so plan two developed limitations with counterweights rather than six one line points.
- 💡Say what would change your mind, such as a sensitivity test on the discount rate or a longer forecast horizon, because conditional judgement is what reaches the top level.
Common Mistakes
- Using annual profit instead of net cash flow, which produces a plausible looking number that answers a different question.
- Converting the part year by multiplying the fraction by ten or by one hundred rather than by twelve, so the months are wrong even though the method was right.
- Recommending the faster project without checking the total returns, when the slower one generates far more cash over its life.
- Dividing total inflows by the years without first deducting the initial cost, which inflates the percentage and reverses the recommendation.
- Giving the answer as a decimal or as a sum of money when the whole point of the measure is a comparable percentage.
- Comparing the percentage with nothing, so the answer states a figure and never says whether it is good for this business.
- Discounting the initial outlay as if it were a future cash flow, which understates the cost and makes weak projects look acceptable.
- Adding the outlay to the discounted inflows instead of subtracting it, producing a large positive figure that cannot be right.
- Reading across the wrong row of discount factors, or using the same factor for every year, so later cash is not discounted at all.
- Calculating all three measures accurately and then stopping, so the answer never says which project the business should choose or why.
- Treating forecast cash flows as facts, when they are estimates that depend on sales forecasts the same paper expects candidates to criticise.
- Recommending the option with the largest headline figure without checking whether the firm has the cash to fund it or the capacity to deliver it.
- Writing that the techniques are unreliable because the figures are estimates, without saying which figure, how far out it might be, and what decision that would change.
- Confusing cash with profit, so average rate of return is worked from cash inflows or net present value from profit, and then criticising the wrong technique.
- Treating net present value as a certain answer because it is the most sophisticated method, when it is the technique most sensitive to an assumed rate.
- Listing limitations as a shopping list with no judgement, when the higher level marks require a supported decision about which limitation matters most here.