3.3 Flashcards
Define Investment appraisal
the process of analysing whether investment projects are worthwhile
What are the 3 main methods of appraisal?
-Payback period
-Average rate of return
-Discounted cash flow
Define payback period
The time it takes for a project to repay its initial investment
Define average rate of return
The total accounting return for a project to see if it meet the target return
Define discounted cash flow / NPV
Net present value calculates the monetary value of the projects future cash flows
How to calculate payback?
-Identify the net cash flows for each period
-Keep a running total of the cash flows
-When the running total moves from negative to positive
-When the total net cash flow becomes positive, that is the end of the payback period
Benefits of using payback?
-Simple + easy to calculate, easy to understand results
-Focuses on cash flows
-Emphasises speed of return; good for markets which change rapidly
Drawbacks of using payback period
-Ignores cash flows after payback has been reached
-Encourages short term thinking
-Ignores qualitative aspects
-Doesn’t create decision for the investment
Define Average Rate of return
The anual percentage return on an investment project based on average returns earned by the project
How to calculate ARR
-Calculate the average annual profit from the investment project (Total net cash flow - initial investment/number of years)
-Divide the average annual profit by the initial investment
-Compare with the target percentage return
Formula for average rate of return
Average rate of return = average annual profit / initial investment
Benefits of using ARR
-Simple to understand and easy to calculate
-Focuses on overall profitability of an investment
-Easy to compare ARR with other rates of return
Drawbacks of using ARR
-Ignores timings of returns
-Focuses on profits rather the cash flows
-Doesn’t adjust to time value of money
What is a decision tree?
-A mathematical model
-Used to structure decision making and to help managers make decisions
-uses estimates & profitabilities to calculate outcomes
-Helps to decide whether the net gain from a decision is worthwhile
Define probability
The chance of an outcome happening
Define expected value
The final cal value of an outcome calculated by multiplying the estimated financial effect by its probability
Net gain
The value to be gained from taking a decision. Calculated by adding together the expected values of each outcome and deducting costs associated with decisions
What are the 4 steps to a decision tree?
- Set out the decision to be made and the options
- Add possible outcomes
- Add in associated costs, probabilities and financial gain for each outcome
- Calculate the expected values and net gain
Advantages of using decision trees
-Choices set out logically
-Options & choices are considered at same time
-Likely costs are considered as well as potential benefits
-Easy to understand & tangible results
Disadvantages of using decision trees
-Probabilities are just estimates, prone to error
-Uses quantitative data only
-Decision making techniques doesn’t necessarily reduce amount of risk
Define critical path analysis
A project analysis and planning method that allows a project to be completed in the shortest possible time
Information needed for CPA:
-A list of all activities required
-The time that each activity will take to complete
-The dependencies between activities
What does CPA calculate?
-The longest path planned activities to the end of the project
-The earliest start time and latest finish time
-Which activities are critical and which have the total float
Define the critical path
The sequence of project activities which add up to the longest overall duration. The critical path determines the shortest time possible to compete the project
Define the float
The duration an activity can be extended or postponed so that the project still finishes within the minimum
Formula for calculating the float
LFT - activity duration - EST
Uses of critical path analysis
-Estimates & minimal project time
-Support project costing and evaluation
-Plan and organises resources
-Prioritises takes
-Helps provide direction
Benefits of CPA
-Helps reuse risk & costs of complex projects
-Encourages careful assessment of requirements of each activity
-Helps spot which activities have slack (float)
-Provides overview of complex project
Drawbacks of CPA
-Reliability is largely based on accurate estimates
-Doesn’t guarantee success of project
-Too many activities may lead to to complex diagram
Define Net present value
Calculates the monetary value now of a projects future cash flows (add together all present values)
Formula for present value
Cash flow x discount factor
Benefits of NPV
-Considers all factors cash flow
-Reflects the risks that future cash flows will not be as expected
-Discount rates allow risk to be counted
Drawbacks of using NPV
-Most complicated method compared with payback & ARR
-Choosing discount is hard
-Results can be influenced
What is critical path analysis?
A project analysis and planning method that allows a project to be completed in the shortest possible time
What does CPA calculate?
-The longest path of planned activities to the end of the project
-The earliest start time (EST) and latest finish time (LFT) that each activity can start and finish
-Which activities are critical and which have “total float”
What does the critical path determine?
The shortest time possible to complete the project
What is the float?
The duration an activity can be extended or postponed so that the project still finished within the minimum time
Which activities represent those on the critical path?
Activities that have an equal EST and LFT
How to calculate the float?
LFT - Activity duration - EST
What are some uses of CPA?
-Estimates a minimum project time
-Plans and organises resources
-Helps provide direction
Advantages of CPA?
-Reduces risk & costs of complex projects
-Encourages careful assessment of each activity
-Helps spot activities that have float
Disadvantages of CPA?
-Reliability is based on estimates
-Doesnt guarantee success of project
-Too many activities may lead to a complex diagram
