A LevelBusinessAQARevision NotesStrategyStrategic Investment DecisionsInvestment Appraisal

Investment Appraisal (AQA A Level Business): Revision Note

Syllabus Edition

First teaching 2026

First exams 2028

Exam code: 7132

Written by: Lisa Eades

Reviewed by: Bridgette Barrett

Updated on 5 August 2026

Introduction to investment appraisal

Investment appraisal involves comparing the expected future cash flows of an investment with the initial outlay for that investment
A business may want to analyse
- How soon the investment will recoup the initial outlay
- How profitable the investment will be
Before an investment can be appraised, key data will need to be collected, including
- Sales forecasts
- Fixed and variable costs data
- Pricing information
- Borrowing costs

The collection and analysis of this data is likely to take some time
- It requires significant experience to interpret the data appropriately before the investment appraisal can take place
Different methods are used to appraise the value of an investment, including:
- The simple payback period
- The average rate of return (ARR)
- The net present value of discounted cash flow

Payback

The payback period is a calculation of the amount of time it is expected an investment will take to pay for itself
Where net cash flows are expected to be constant over time, the payback period can be calculated using the formula

$Payback period = \frac{Initial outlay}{Net cash flow per period} = Years / months$

Worked Example

Gomez Carpets is considering an investment in a new storage facility at a cost of £200,000. It expects additional net cash flow of £30,000 per year as a result of the investment.

Calculate the payback period for the investment.

Divide the initial outlay by the additional expected net cash flow

$\begin{array}{l} = \frac{£ 200, 000}{£ 30, 000} \\ = 6.67 years \end{array}$

Convert the outcome to years and months

6 years
0.67 years = 8.04 months
Payback period = 6 years and 8 months

Worked Example

Hammer and Son provides a household repairs service that has recently employed a new handywoman who requires her own van. The new van will be purchased for £32,000

The net cash flows are expected to vary over the five years following its purchase and are shown in the table below.

Year	Net cash flow (£)	Cumulative cash flow (£)
0	(32,000)	(32,000)
1	14,000	(18,000)
2	10,000	(8,000)
3	6,000	(2,000)
4	3,000	1,000
5	2,000	3,000

Calculate the payback period for the van.

The final year where the cumulative cash flow is negative

In this case the cumulative cash flow figure is -£2,000 at the end of Year 3
This is the remaining amount (outlay) outstanding.

Monthly net cash flow for the next year

$\begin{array}{l} = £ 3, 000 \div 12 (months) \\ = £ 250 \end{array}$

Divide the remaining outlay outstanding by the monthly net cash flow

$\begin{array}{l} = £ 2000 \div £ 250 \\ = 8 months \end{array}$

Identify the payback period

In this case the payback period is 3 years and 8 months

Evaluation of the payback period method

Advantages	It is a simple method to calculate and understand It is particularly useful for businesses where cash flow management is vital Businesses can identify the point at which an investment is paid back and contributing positively to cash flow It is also useful where new technology is introduced regularly Businesses purchasing equipment can calculate whether an investment ‘pays back’ before an upgrade is available
Disadvantages	It provides no insight into the profitability of investments Payback only considers the total length of time to recover an investment Neither the timing nor the future value of cash inflows is considered It may encourage a short-termism approach Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives

Advantages

It is a simple method to calculate and understand
It is particularly useful for businesses where cash flow management is vital
Businesses can identify the point at which an investment is paid back and contributing positively to cash flow
It is also useful where new technology is introduced regularly
Businesses purchasing equipment can calculate whether an investment ‘pays back’ before an upgrade is available

Disadvantages

It provides no insight into the profitability of investments
Payback only considers the total length of time to recover an investment
Neither the timing nor the future value of cash inflows is considered
It may encourage a short-termism approach
Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives

Average rate of return

The average rate of return compares the average profit per year generated by an investment with the value of the initial outlay
The average rate of return is calculated using the formula

$ARR = \frac{Average annual return}{Initial outlay} \times 100$

The outcome of the formula is expressed as a percentage, which makes it easy to compare different investment options

Worked Example

Creative Frames, a small artwork framing business, is considering an investment of £40,000 in new machinery. Megan, the business owner, believes that total cash inflows over a 6-year period will be £140,000 and total cash outflows will be £92,000.

Calculate the average rate of return of the proposed investment.

Total profit over the lifetime of the investment

$\begin{array}{l} Total cash inflows - Total cash outflows = Total profit \\ = £ 140, 000 - £ 92, 000 = £ 48, 000 \end{array}$

Average annual profit

$\begin{array}{l} = £ 48, 000 \div 6 years \\ = £ 8, 000 \end{array}$

Divide the average annual profit by the initial outlay

$\begin{array}{l} = £ 8, 000 \div £ 40, 000 \\ = 0.2 \end{array}$

Average rate of return

$\begin{array}{l} = 0.2 \times 100 \\ = 20 % \end{array}$

Evaluation of the average rate of return (ARR)

Advantages	It considers all of the net cash flows generated by an investment over time It is easy to understand and compare the percentage returns with each other
Disadvantages	As it depends on an average of cash flows, it ignores the timing of those cash flows The opportunity cost of the investment is ignored as values are neither expressed in real terms - nor adjustments made - for the impact of interest rates and time

Net present value

The net present value (NPV) evaluates the value of an investment or a project, taking into account the effects of interest rates and time
- It represents the present value of the future cash inflows minus the present value of the future cash outflows
- To get the present value, the future value has to be discounted (reduced)
This discounting method recognises
- That money received in the future is worth less than money received today due to inflation
- The opportunity cost of not having the money available for other uses
To calculate the net present value of an investment, the value of all future net cash flows in today’s terms need to be calculated first – and then discounted using a table
- The cost of the initial investment is deducted from the total of the discounted net cash flows
  - If future net cash flows minus the initial investment is positive, then the investment is likely to be worthwhile
  - If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile
Discounted cash flows are calculated using discount tables which allow future cash flows to be expressed in today’s terms

Worked Example

Brownsea Sightseeing Tours Ltd is considering purchasing a new pleasure craft at a cost of £325,000. It expects the investment to achieve the following net cash flows over five years of operation

Year	Net cash Flow (£)	10% Discount Factor
0	(325,000)	1.00
1	110,000	0.91
2	90,000	0.83
3	75,000	0.75
4	65,000	0.68
5	60,000	0.62

Using the 10% discount factor, calculate the NPV of the leisure craft investment.

Discounted cash flow for each year

Table showing net cash flow, 10% discount factor, and discounted cash flow from year 0 to 5, with calculations highlighted on the right.

Total of discounted cash flow values for each year, including Year 0

$\begin{array}{l} = (£ 325, 000) + £ 100, 100 + £ 74, 700 + £ 56, 250 + £ 44, 200 + £ 37, 200 \\ = (12, 550) \end{array}$

The net present value of the investment is -£12,550
This suggests that the investment in the new pleasure craft is not financially worthwhile

Evaluation of the net present value method

Advantages	It considers the opportunity cost of money Discount tables are used to calculate forecast future values of net cashflows Businesses may choose different discount tables (20%, 10%, 5% etc) to adjust the level of risk involved in a project, allowing a range of scenarios to be considered
Disadvantages	It is more complicated to calculate and interpret than other methods of investment appraisal Accurately forecasting future cash flows can be difficult Selecting an appropriate discount rate can be challenging, as even small changes in the discount rate can impact the calculated NPV The NPV method only considers the financial costs and benefits of a project and ignores qualitative factors

Advantages

It considers the opportunity cost of money

Discount tables are used to calculate forecast future values of net cashflows
Businesses may choose different discount tables (20%, 10%, 5% etc) to adjust the level of risk involved in a project, allowing a range of scenarios to be considered

Disadvantages

It is more complicated to calculate and interpret than other methods of investment appraisal
Accurately forecasting future cash flows can be difficult
Selecting an appropriate discount rate can be challenging, as even small changes in the discount rate can impact the calculated NPV
The NPV method only considers the financial costs and benefits of a project and ignores qualitative factors

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Investment Appraisal (AQA A Level Business): Revision Note

Introduction to investment appraisal

Payback

Worked Example

Worked Example

Evaluation of the payback period method

Average rate of return

Worked Example

Evaluation of the average rate of return (ARR)

Net present value

Worked Example

Evaluation of the net present value method

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Author: Lisa Eades

Reviewer: Bridgette Barrett