3.3 Flashcards
definition of investment appraisal
process of analyzing whether investment projects are worthwhile
three main methods of investment appraisal
- payback period (time)
- average rate of return %
- discount cash flow (NPV) £
payback period
time it takes for a project to repay its initial investment
benefits of using a payback period
- simple to calcultate
- focus on cash flows
- emphasizes speed of returns
- comparable
drawbacks of using a payback period
- ignore cash flows after payback has been reached
- no account of the “time value of money”
- ignores qualitative aspects of the decision
- Short-term thinking
what is ARR
annual % return on an investment project based on average returns earned by the project
equation for ARR
total net cash - initial investments =A
A / initial investments x 100 = B
B / years = ARR
benefits of using ARR
- simple to understand and calculate
- comparable with other target rates
drawbacks of ARR
- ignore timings of result
- focuses on profits rather than cash flows
- not adjusted for time-value of money
NPV
calculates the monetary value now of a projects future cash flow
discounting definition
method used to reduce the future value of cash flows to reflect the risk that they may not happen
what is the time-value of money
- better to receive cash now then in the future
- future cash flows are worth less
NPV calculation
net cash flow x discount factor
NPV analysis
NPV - initial investment
+ve = accept project
-ve = reject project
benefits of NPV
- considers all future cash flows
- reflects risks
- different levels of risks can be accounted for by adjusting the discount rate
- straightforward decision
drawbacks of NPV
- choosing the discount rate is hard - as you do not know what the future bank interest rate will be
what is network analysis
technique used to identify the order in which all activities need to be completed when planning a complex project
how do network and critical path diagrams work
organise activities to show which activities can be done simultaneously and which are dependent on earlier activities
what does a critical pathway identify
the shortest time in which a project can be completed
network diagrams features:
- made up of 3 nodes
- EST earliest start time (top, right)
- LFT - latest activity can finish without delaying the project
- the node number based on the order in which it is drawn
what does the LFT on the final node need to match
matches the EST on that node
What happens when two or more activities of in the same node for LFT
choose the lower number
critical path analysis advantages
- shorten overall tiem of proejct
- allows for just in time
- identifies critical activities
- improves focus on the projects
critical path analysis disadvantages
- relies on estimations
- doesn’t take into account external influences
- large projects can be to complex for CPA
what is the total float
the amount of time an activity can be delay without affecting the end time of the entire project
total float formula
LFT this activity - duration - EST this activity
what is free float
amount of time that a task can be delayed without delaying the following task
free float formula
EST next - duration - EST this
what does a negative NPV mean
the firm could get a better return by putting their money in a savings account, than going ahead with the project
a positive of critical path analysis
firms can forecast their cash flow, as definitive start times allow the firm to budget accurately, and know what activities need cash
two approaches to sales forecasting
- extrapolation
- correlation
extrapolation definition
uses trends established from historical data to forecast the future
moving averages used in extrapolation
- moving average takes a data series and “smooths” the fluctuations in data to show an average
- the aim is to take out extreme data
factors to consider with moving averages
- product life cycle
- pace of technological innovation
- growth of the global economy
- market saturation
extrapolation
advantages
- simple method of forecasting
- mot much data required
- quick and cheap
extrapolation
disadvantages
- unreliable due to fluctuations in historical data
- assumes past trends will continue
- ignores qualitative factors
correlation definition
looks at the strength of a relationship between two variables
correlation variables
- indpendant variables - change
- dependant variables - measure
what is the regression line
plots the mathematical relationship between the variables based on the data points
how to work out if you have a strong correlation
there is little room between the data points and the line of best fit
how to work out if you have a weak correlation
the data points are spread quite wide and far away from the line of best fit
factors affecting sale forecasts
- consumer trends
- economic variables
- competitor actions
circumstances where sales forecasts are likely to be inaccurate
- start-up business
- disruption of technological change
- changes in market share
- management that have demonstrated poor forecasts in the past
what is a decision tree
- A mathematical model
- Used to help managers make decisions
- Uses estimates and probabilities to calculate likely outcomes
- decides whether the net gain from a decision is worthwhile
what does the expected value mean in a decision tree
The financial value of an outcome calculated by multiplying the estimated financial effect by its probability
what does the net gain mean in a decision tree
value to be gained from taking a decision. Calculated by adding together the expected value of each outcome and deducting the costs associated with the decision
advantages of decision trees
- Choices are set out in a logical way
- Potential options & choices are considered at the same time
- costs are considered as well as benefits
- Easy to understand & tangible results
disadvantages of decision trees
- Probabilities are just estimates
- Uses quantitative data only
- Assignment of probabilities and expected values prone to bias
- Decision-making technique doesn’t necessarily reduce the amount of risk
