Investment appraisal techniques
Investment risk and sensitivity analysis
A realistic assessment of risks is essential. In practice, the biggest risk for many investments is the disruption they can cause. For example, it can take longer than expected to implement new systems and train employees. The disruption can also lead to a loss of business.
You need to be clear about your underlying assumptions and how reliable they are. If you are making a significant investment, it can be worth assessing the expected return using a range of different assumptions.
For example, you might look at what would happen if a key customer decided not to buy a new product you were developing - see plan and forecast sales.
If you cannot predict the future with confidence, you may prefer to choose a more flexible investment option. For example, you might prefer to get premises on a short-term licence rather than committing to a long-term lease or purchasing premises outright.
Appraising an investment from several different angles can be the most effective way of deciding whether it is worth pursuing.
Techniques like payback period can be used as an initial screen: if an investment doesn't meet your payback target, you eliminate it. For more information see payback period.
If a project passes this first test, you can go on to use more complex calculations such as net present value - see discounting cashflow methods.
Crucially, you should also use your own judgement to consider non-financial factors and to think about how the investment fits your overall strategy - see implementing a strategic plan.