3.2.2 Investment appraisal Flashcards
What can investment appraisal be applied to
strategic decisions
define investment appraisal
process of using techniques to analyse whether an investment in a project is worthwhile
what is the purpose in investment appraisal (4)
-reduces risk
-assesses potential returns of a project
-decide between 2 projects
-show to investors
what does investment appraisal compare
net cashflow with initial investment
why can it take managers weeks/ months
data can be difficult to find and analyse
what are the 3 quantitative methods
- payback
- average rate of return (ARR)
- net present value (NPV)
what is formula for payback?
sum invested/ net cash per time period
what is formula for exact payback?
outlay outstanding/ monthly cash in year of payback
what is the criterion level
18 months
why can the time of payback be delayed (3)
-production issues
-product recall
-unexpected rise in costs
state 3 positives of payback
-straight forward to calculate, interpret + compare to projects
-takes timings of cashflows into account so adjustments can be made
-emphasis on speed of return - important in dynamic markets
state 3 negatives of payback
-ignores what happens after payback
-ignores time value of money and life of assets
-ignores qualitative aspects of decision making
what is the formula for ARR
(average annual return/ initial outlay) x100
what does ARR compare
average annual profit from an investment with the money invested
what are the 3 steps to ARR
- identify lifetime profit
- divide by number of years
- calc. annual profit as a % of initial outlay
what is the general rule for ARR
should be higher than return a business would get by investing on a bank (normally 15%)
what are 3 positives to ARR
-focuses on profitability + provides % that can be compared
-uses cash flow over a lifetime of the project
-important as profitability key
what are 3 negatives to ARR
-ignores value of money
-ignores the cash flow timings
-doesn’t take into account qualitative factors
what does NPV take into account
time value of money using discount factors
what are 3 positives of NPV
-takes time value of money into account, placing emphasis on earlier cash flows
-looks at cash flows for the full life of the project + takes inflation into account
-considers the opportunity cost of investment in a project vs putting into an account
what are 3 negatives of NPV
-can be complicated method to communicate
-difficult to select most suitable discount rate - project rejected as a result?
-only comparable to projects where initial outlay is the same
