3.3.2 Investment Appraisal Flashcards
What is meant by the payback method of investment appraisal
Payback measures the length of time before an investment starts to generate profit. The shorter the payback the better
What is the formula to use if the payback period happens mid-way through a year
To calculate the number of months if the payback happens part way through a year, calculate the total net cash flow for the full year before payback is reached, then calculate: what you need, what you get then multiply by 12
Why might it be advisable to use another method of investment appraisal along side payback in order to decide on an investment project
Payback only tells the business how long it takes to payback, not the total return on investment which might also be important
Identify 3 strengths of payback method
Strengths: time is important to judge value of investment as longer the investment payback, the increased uncertainty, useful during time of uncertainty, simple and easy to likely to me misinterpreted
What are the 5 steps to calculate ARR
- calculate average annual profit (adding up net cash flows for lifetime of project)
- deduct initial cost of investment
- divide result by number of years
- divide this by the initial cost of the investment
- multiply by 100 to get %
3 strengths of ARR
- creates a simple % return which can be compared to target rate if return
- looks at profitability which is an important method of success
3 weaknesses of ARR method
- uses profit flows which can be harder to predict if far away because of external influences
- profits later on in project may be less valuable to shareholders than early profits
- doesn’t take into account the time value of money
What is meant by net present value
Means the value of money now of money in the future.
How to work out net present value
Discount future money flows as money in the future is worth less than money now. Because if we had money now we would earn interest with the bank
2 strengths of NPV method
- gives clear decision making rule: as long as NPV is worth doing
- takes into account that money in the future is worth less than money now
- flexible as there is a choice of discount rate
2 weaknesses of NPV method
- doesn’t calculate total return as a percentage which makes it harder to compare investment projects
- future cash flows are forecasts and could be subject to error
- NPV is quantitative and may be better to take into account qualitative factors
What does it mean to apply a 10% discount factor
A discount factor is the amount by which a future cash flow is reduced in order to calculate what it is worth now
What does a positive NPV of an investment mean
A positive NPV means that there is a return on an investments despite the fact that future cash flows have been discounted
3 non-financial factors affecting investment decisions
Amount of uncertainty in the market, how much spare capacity a business has, the impact on the brand that the investment might have
Which investment appraisal method is likely to be favoured by firms looking to reduce risks involved in their investments
Payback is likely to be used when there is concern about risk. This is because the quicker the payback, the less risk and the less impact the investment will have on cash flow
