3.3.2 Investment appraisal Flashcards
capital expenditure
- purchase of assets
- will stay in business for medium to long term
risk vs return/reward
- all investment have risk & opportunity costs
risks: demand change, damage env image, higher FC, yield return when (short termist, liquidity issues), non current asset depreciate
reward: cope demand (increase rev), USP, increase capacity utilisation, gain non current asset increase value of SOFP
6 Examples of Typical investment decisions business makes
- 1launch new product/development (R&D)
- 2change ownership
- 3new production technique
- 4expansion & new tech (purchase NC asset)
- 5marketing campaign
- 6readjust internal infrastructure
8 reasons why is investment important
1-increase value of capital 2-competitive (innovation) 3-grow = EOS 4-dominant in (market price) 5-useful asses ability to achieve corporate obj 6-viability 7-useful for investors 8-allows balance of risk vs future profitability
investment appraisal
-process of analysing finanical merits of a possible future investment
3 assumptions with investment appraisal
- costs and revenue can be easily forecasted
- key economic variables dont change (interest rates)
- seek to profit maximise (all business)
2 numerical success criteria with investment appraisal
- total future profit earnt
2. speed of cost recoupment
3 types of investment appraisal
- average accounting rate of return
- payback
- net present value
payback
-measures time period required for earnings from an investment to recoup its original cost
month of payback
income needed divided by (income over next yr divided by 12)
limitations to payback
- ignore profitability
- cannot tell inflows after payback period (later cash receipts)
- commitments (detract paying inv)
- no timings receipts within each year (steady?)
- encourage short termist
- no consideration of value of money
- ignore total return on investment and timing of return prior
5 things to consider with payback
- seasonality
- project lifespan
- cash inflows
- technical issues
- current cash flow situation
- set upper limit on time allowed otherwise rejected
- rank projects based on speed
quan: recoup investment earlier
qual: demand in area = growth, difference in investment (have capital), forecasted numbers (higher scope for growth), location of/in the area, competitors in the area
benefits of payback
- quick and simple (new business/small/ start ups)
- useful if investing in ICT & short plc as well as if using external SOF
- widely used minimise risk give weight to early cash inflows
- may be more accurate as ignores longer term forecasts which may be less accurate
- takes into account timing of cash flow
- useful for business with weak cash flow
average rate of return (ARR)
method used to calculate the percentage rate of return on each possible investment
- more complex tool (profitability)
- allows comparison of investment result with other possible investment (compare interest rates) opportunity cost
- commercial investment = risk (trade off = safest = bank)
- reject project without expected % ARR and rank projects
investment > interest
formulae for ARR
average annual profit divided by assets initial cost x100
average annual profit :
= total profit = rev - cost
= total profit divided by no of years
limitations with ARR
- not 100% accurate
- based on forecasts
- assets depreciate
- inflation (doesn’t consider)
- may have excess costs
- treats all money equal irrespective of when received
- ignores time value of money/ignores timings of cash flow
- ignores risk that projections of future sales = more inaccurate further into the future they are
4 purpose of investment
- replace obsolete equipment
- expand productive capacity
- reduce production costs per unit (EOS)
- new products = new markets
net present value
present value = actual sum of money concerned divided by (1 + rate of discount) to the power of no of years
5 non financial factors that can affect investment decision
- corporate objectives (long term growth to boost business)
- company finance (borrowing, irresistible ARR, external?)
- confidence in data (how forecasts made, who made them, evidence behind them, biased?, data from independent source)
- social responsibility (recycling = low ARR but proceed for PR reasons - boost morale in staff, ethically right and impact on environment)
- effect on employees/new working practice/conditions
4 qualitative factors affecting investment decision
1.non financial factors
2. investment criteria (set minimum financial targets)
3. risk and uncertainty
(satisfactory returns estimates - uncertainty = increases further ahead the projections, underlying liquidity enough to withstand losing initial outlay of investment)
4. external environment
4 external environment factors affecting investment decision:
- state of economy (recession demand decreases)
- pressure group activity
- level of technological progress in industry
- legislation
benefits of ARR
- consider profitability/total profit made (profit is a common corporate obj)
- easy to compare % return vs other investments
- can compare with interest rates
- can compare with other financial targets (ROCE)
net present value (NPV)
-higher NPV = more financial worthwhile
income stream x discount factor
discounted cash flow
-process of adjusting the value of earnings received at some future date to its present value (reverse of adding interest)
discounting
reduces the value of earning (opportunity cost of investment)
(rate) = selected should reflect the interest rates expected for the life of the investment or choose target rate
present value
value of future income converted to current worth
time value of money
based on principle present worth is greater than future worth
-underpinned by risk and opportunity cost
5 Advantages of NPV
- 1discounting reduces impact of long term, less likely cash flows
- 2decision making mechanism (reject projects with negative NPV)
- 3considers timing of cash flow and size of them in arriving at an appraisal
- 4rate of discount = varied = different economic circumstances
- 5considers time value of money and takes opp cost into account
4 Disadvantages of NPV
- 1can’t compare with different initials costs
- 2complex to calculate and explain
- 3rate of discount is critical if high = fewer projects profitable
- 4depends heavily on rate of discount used interest rates may be inaccurate
