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By the end of this topic, you should be able to:
Note: Questions on discounted payback will not be set. Questions involving a residual value at the end of a project will not be set.
When a business wants to spend a large sum of money on something — for example, buying a new machine, building a new factory, or launching a new product — it needs to decide whether that spending is worthwhile.
This decision-making process is called capital investment appraisal (sometimes just "investment appraisal"). It involves comparing the money a business spends on a project against the money the project is expected to generate in the future.
The spending on the project is called the initial investment (or initial outflow). The money generated by the project over time is called the net cash inflows.
Before applying any appraisal technique, you need to understand and identify the cash flows of a project.
This is the amount of money paid out at the start of the project (usually labelled as Year 0). It is a cash outflow — money leaving the business.
Each year after the project begins, the business receives cash from the project (e.g. from sales). After deducting any cash costs for that year, what remains is the net cash inflow for that year.
Net cash inflow = Cash received from project − Cash costs of running project
Important: In investment appraisal, we use cash flows, not profit figures. This means we do not deduct depreciation (because depreciation is not a cash payment — no money actually leaves the business when depreciation is recorded).
A business buys a machine for $50,000 at Year 0. The machine is expected to generate:
| Year | Net Cash Inflow |
|---|---|
| 1 | $15,000 |
| 2 | $18,000 |
| 3 | $20,000 |
| 4 | $12,000 |
The initial outflow is $50,000. The net cash inflows are as shown above.
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