3.3.2 Investment Appraisal

Question 1

Investment appraisal:

- Payback period

Answer 1

The time it takes for a project to repay its initial investment

Calculation
1- Identify the net cash flows for each period (net cash-flow = inflows - outflows)
2- Keep a running total of the cash flows
- initial investment (an outflow)
- when does the running total move from negative (outflow) to positive (inflow)
- when total net cash flow becomes positive - end of payback period

Work out cumulative cashflows until it is positive
Amount before positive ÷ year of months ur working out X12 - in year and months

Question 2

Investment appraisal

- Pay back period: advantages and disadvantages

Answer 2

Pay back period - the time it takes for a project to repay its initial investment

Benefits
Simple and easy to calculate and understand the results
Focuses on cashflows
Emphasises speed of return : good for markets which change rapidly
Straightforward and easy to compare with competing projects

Drawbacks
Ignores cashflows after payback has been achieved
Encourage quickest payback not highest return
Takes no account of the time value for money (main benefit of discounted)
May encourage short term thinking
Ignores qualitative aspects of a decision
Does not actually create a decision for the investment - is payback acceptable

Question 3

Investment appraisal:

- Average annual return APR

Answer 3

The annual % return on an investment project based on average returns earned by the project

Benefits
Simple to understand and easy to calculate
Focuses on overall profitability of an investment project
Easy to compare APR with other key target rate of return to help make a decision
Uses all the returns generated by a project

Drawbacks
Ignores timing of returns
Focuses on profits rather than cash flows
Does not adjust for the time value of money

Calculation
add all inflows to project cost ÷ years ÷ project cost X100 %

Question 4

Net present value

Answer 4

Calculates the monetary value now of a projects future cash flows

Time value of money -
Better to receive cash now as future cash flows are worthless, uses discounted factors to bring cashflows to their present value, discount factor is determined by the rate of return

Benefits
Considers all future cash flows
Reflects the risks that future cash flows will not be as expected
Different levels of risk can be accounted for by adjusting discount rate
Creates a straight forward decision - positive may mean project should go ahead

Drawbacks
Most complicated method
Choosing discount rate= hard, particularly for long projects
Result can be influenced using discount rate

Timex all by discount then add up and - project cost