3.3.2 - Investment Appraisal Flashcards
Def investment appraisal
The process of analysing the financial merits of a possible future investment
The three methods of investment appraisal
- payback average
- average rate of return
- net present value
3 assumptions investment appraisal makes
- cost and revenues can be easily forecasted
- key economic variables don’t change
- business seeks to profit maximise
When is investment appraisal used
- will long term investments give the best return?
- projects eg new machinery, premises and research
Def payback
Assesses the period of time a business must wait until its initial investment has been recovered allowing a firm to prioritise risk reduction when making investment decisions
Formula payback
Month of payback = income needed/ contribution per month
Formula for month it occurs
Outlay outstanding/ monthly cash flow in year of payback
Description ARR
Considers profit generates by an investment, involves calculating the average annual profit as a percentage of the initial outlay
3 steps involved in calculating ARR
1) calculate total profit over the lifetime of the project by adding all net cash flows and deducting the initial outlay
2) divide by the number of years the project lasts
3) apply formula
ARR formula
(Average annual profit / initial outlay) x 100
Interpretation of ARR
The higher the ARR, the more profitable the investment
Description of NPV
Takes into account the money in the future is not worth what it is today, so adds in a discount table to make it more realistic
NPV formula
Total discounted cash flows - initial cost of investment
Interpretation of NPV
A positive NPV shows a project generates a greater return on initial outlay than simply putting the money in the bank at an investment rate equal to the percentage discounting factor used.
Def short termism
Is the tendency to focus on achieving short term objectives by taking decisions that may preclude better, long term options
Strengths of payback
- easy to calculate and understand
- more accurate as ignored longer term forecasts
- takes into account the timings of cash flows
- useful for a business with weak cash flows
Limitations of payback
- tells us nothing about profitability
- ignores what happens after payback is achieved
- may encourage a shirt-thermistor attitude
Strings of ARR
- clear focus on profitability
- considers cash flows over the while projects lifetime
- easy to compare with other measures as expressed as a percentage
Limitations of ARR
- ignores the timings of cash flows
- includes forecast data from far in suture which reduces reliability of results
Strengths of net present value
- takes the opportunity cost of money into account
- considers both amount and timing of cash flows to indicate profitability
Limitations of NPV
- complex to calculate and communicate
- meaning is often misunderstood
- only comparable between different projects if the initial outlay is the same
4 other non financial factors affecting investment decisions
Corporate objectives, company finances, confidence in data, social responsibilities
