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How do businesses decide whether an investment is worthwhile?

The methods of investment appraisal (payback period, average rate of return and net present value), how to calculate and interpret each, and the quantitative and qualitative factors in an investment decision.

A focused answer to AQA A-Level Business 3.5, covering the methods of investment appraisal (payback period, average rate of return and net present value), how to calculate and interpret each, and the quantitative and qualitative factors that shape an investment decision.

Generated by Claude Opus 4.811 min answerUpdated 2026-06-02

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
Payback period
Average rate of return
Net present value
Qualitative and quantitative factors

What this dot point is asking

AQA wants you to calculate and interpret the three investment appraisal methods (payback, average rate of return and net present value), and weigh the quantitative results against the qualitative factors in a real decision. Expect a Paper 2 calculation worth up to 12 marks, often followed by a recommendation that must use both the numbers and the context.

Payback period

To calculate it, build a running cumulative cash flow until it reaches the initial cost. When the cost falls within a year, multiply the fraction of that year's inflow still needed by 12 to express the answer in months.

Average rate of return

Net present value

Net present value (NPV) discounts each future cash flow back to its present value using a discount factor (provided in the exam), then subtracts the initial cost. The discount factor shrinks later cash flows more heavily, capturing the idea that money has a time value. A positive NPV means the project earns more than the required rate of return and should be accepted; a negative NPV means it destroys value. NPV is the most complete method because it uses the whole life of the project and the time value of money, but it depends on the chosen discount rate and on forecasts that grow less reliable further out.

Worked appraisal: payback, ARR and NPV

Step 1: set up the project

A machine costs $\pounds100{,}000$ and is forecast to bring in net cash inflows of $\pounds40{,}000$ in each of years 1 to 3, then $\pounds20{,}000$ in year 4.

Step 2: payback

Cumulative cash: year 1 $\pounds40{,}000$ , year 2 $\pounds80{,}000$ , then $\pounds20{,}000$ of the year-3 inflow completes recovery. That is $\frac{20{,}000}{40{,}000} = 0.5$ of year 3, so payback is $2.5$ years.

Step 3: ARR

Total inflows $= 40 + 40 + 40 + 20 = \pounds140{,}000$ . Total profit $= 140{,}000 - 100{,}000 = \pounds40{,}000$ . Average annual profit $= \frac{40{,}000}{4} = \pounds10{,}000$ .

\text{ARR} = \frac{10{,}000}{100{,}000} \times 100 = 10\%

Step 4: NPV at a 10 percent discount rate

Using discount factors of $0.909$ , $0.826$ , $0.751$ and $0.683$ : present values are $36{,}360 + 33{,}040 + 30{,}040 + 13{,}660 = \pounds113{,}100$ . NPV $= 113{,}100 - 100{,}000 = +\pounds13{,}100$ .

Step 5: recommend

Payback within the project life, a 10 percent ARR and a positive NPV all point the same way, so the project is worthwhile, subject to forecast reliability and the firm's target return.

Qualitative and quantitative factors

The numbers are necessary but not sufficient. A full decision also weighs the firm's objectives (a survival-focused firm prioritises fast payback), the level of risk and reliability of the forecasts (longer projects are more uncertain), the state of the economy and interest rates, ethics and environmental impact, the availability of finance, and how the project fits the wider strategy. A project with the best NPV can still be rejected if it carries unacceptable risk or clashes with the firm's mission.

Exam-style practice questions

Practice questions written in the style of AQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

AQA 20229 marksA logistics firm is appraising a

\pounds200{,}000

vehicle that is forecast to generate net cash inflows of

\pounds60{,}000

in year 1,

\pounds80{,}000

in year 2,

\pounds80{,}000

in year 3 and

\pounds60{,}000

in year 4. Calculate the payback period and the average rate of return, and recommend whether to invest. (9 marks, Paper 2 quantitative section)

Show worked answer →

Show the running cumulative cash flow for payback.

End of year 1: $\pounds60{,}000$ recovered. End of year 2: $\pounds140{,}000$ . The remaining $\pounds60{,}000$ comes from year 3's $\pounds80{,}000$ inflow, so the fraction is $\frac{60{,}000}{80{,}000} = 0.75$ of year 3.

Payback $= 2.75$ years (2 years 9 months).

ARR: total inflows over four years $= 60 + 80 + 80 + 60 = \pounds280{,}000$ . Total profit $= 280{,}000 - 200{,}000 = \pounds80{,}000$ . Average annual profit $= \frac{80{,}000}{4} = \pounds20{,}000$ .

\text{ARR} = \frac{20{,}000}{200{,}000} \times 100 = 10\%

Recommendation: payback of under three years is reasonable for a vehicle with a four-year life, and a 10 percent ARR beats typical borrowing costs, so on the numbers the investment is worthwhile, subject to the reliability of the forecasts and the firm's target criteria. Markers reward the cumulative method for payback, the correct ARR formula and figure, and a justified recommendation that weighs both measures.

AQA 20196 marksAnalyse why a business might prefer net present value to the payback method when appraising a long-term investment. (6 marks)

Show worked answer →

NPV discounts every future cash flow back to its present value using a discount factor, then subtracts the initial outlay. This means it accounts for the time value of money (a pound received in five years is worth less than a pound today) and it uses the whole life of the project, not just the period up to repayment.

Payback, by contrast, ignores the time value of money entirely and ignores all cash flows after the initial cost is recovered, so a project with a quick payback but poor later returns can look better than a slower project that creates far more value overall. For a long-term investment, where most of the value lands in later years, NPV gives a truer picture and a clearer accept or reject signal (a positive NPV adds value). Markers reward the two specific advantages (time value of money and whole-life cash flows) explained as a chain, and a link to why this matters more for long-term projects.

Related dot points

Sources & how we know this

AQA A-level Business (7132) specification — AQA (2015)