3.8 Investment appraisal

Every business decision that commits money today in exchange for returns tomorrow is an investment. Buying a new production line, opening a second branch, developing a new product: each carries a cost, a risk, and an expected payoff. Without a systematic way to evaluate these, managers rely on gut feeling, which is not a sound basis for committing thousands or millions of dollars.

Three quantitative techniques are used in IB Business Management:

• Payback period: how long it takes for cumulative cash inflows to recover the initial outlay
• Average Rate of Return (ARR): the average annual profit expressed as a percentage of the initial investment
• Net Present Value (NPV): the sum of all future cash inflows discounted to today's value, minus the initial investment

HL only: NPV is assessed only at Higher Level. SL students are assessed on payback period and ARR.

It answers a straightforward question: when does the business get its money back? This matters most when a firm has limited cash reserves or operates in an industry where technology changes rapidly and long-term forecasts are unreliable.

Calculating the payback period

Build a cumulative cash flow column year by year. The payback period is the point at which that cumulative total reaches zero (i.e. equals the initial outlay).

If payback falls exactly at the end of a year, that year is the answer. If payback falls part-way through a year, use the partial-year formula:

$\text{Payback Period}=\text{Number of full years}+\frac{\text{Amount still to recover}}{\text{Cash inflow in the next year}}$

The fraction of a year is usually converted to months by multiplying by 12.