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Strategic decisions — whether to enter new markets, develop new products, or diversify — invariably require investment. Before committing resources, businesses need methods to evaluate whether a proposed investment is financially worthwhile. Investment appraisal provides the quantitative tools for making these decisions. This lesson covers the two simplest methods: payback period and average rate of return (ARR).
Investment appraisal is the process of evaluating whether a proposed capital investment is likely to generate sufficient returns to justify the cost. Capital investments typically involve large, upfront expenditures on assets such as:
All investment appraisal methods compare the initial cost of the investment with the expected future returns (net cash flows) it will generate.
The payback period is the length of time it takes for an investment to generate enough net cash inflows to recover its initial cost. In other words, it answers the question: "How long until I get my money back?"
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