3.3.2 Investment appraisal Flashcards
define investment appraisal
the evaluation of an investment project to determine whether or not it is likely to be worthwhile
define average rate of return
a method of investment appraisal that measures the net return per annum as a percentage of the intial spending
define capital cost
the amount of money spent when setting up a new venture
define discounted cash flow
a method investment appraisal that takes interest rates into account by calculating the present value of future income
define investment
the purchase of capital goods
define net cash flow
cash inflows - cash outflows
define net present value
the present value of future income from an investment project, minus the cost
define payback period
the amount of time it takes to recover the cost of an investment project
define present value
the value today of a sum of money available in the future
what does investment appraisal attempt to determine?
the value of capital expenditure projects, it enables the business and its investors to compare projects -> expansion and meet objectives
What is meant by capital expenditure?
Assets which will be used in the long term
Is IA used in the planning process, if so what for?
yes
used to determine whether long term investments will give the best monetary return
etc. new machinery, new premises
How do we calculate payback periods?
Year 0 is when the investment was made so the value is a minus
1. Add the years of the data to equal the value of the investment
if the value of the return is higher than the investment
-divide the years potential profit by 12 to get how much is made in a month
-divide the amount needed the profit made in a month to get the amount of months needed to payback the full investment
give 3 Drawbacks of using simple payback
too simple
cash earnt after the payback period is ignored
The profitability of the method is overlooked as only looks at the speed of payback
give 3 advantages of using simple payback
it is simple to use and to interpret
firms can adopt this method if they are experiencing cash flow problems as the project will payback the investment more quickly than others
useful when tech changes rapidly to recover the costs of R&D
how should payback be interepted?
- the length of time that money is invested at risk
-look for shortest payback period
What is the formula to work out the ARR?
ARR (%) = Net return per annum/ Capital outlay (cost) X 100
what does ARR measure?
the net returns each year as a percentage of the capital cost of the investment
what are the steps to work out ARR (walk through for formula)
- Add up net cashflows
- Minus cost of project
- Divide the value by the number of years the project runs over
- then divide the value by the cost of the project and multiply by 100
How should a business interpret ARR rates?
-shows average profit made each year based on the investment
- businesses should look for the highest percentage of return
What is a disadvantage of ARR?
doesn’t take into account the effects of time on the value of money
what are some advantages of using ARR?
clearly shows the profitability of a project
allows a range of products to be compared
easy to identify the opportunity cost
what does Net present value account for?
what the cashflow or profit earned in the future is worth at the present value
how to calculate net present value?
1st calculate the present value by multiplying the net cash flow by the discount rate
2nd add all the present values to give the net present values and then minus the initial cost
how should NPV be interpreted?
-Shows how much profit is made in the future is really worth in todays terms
-Businesses should choose the highest NPV
give 3 drawbacks of NPV
too complex
not used by small businesses
the rate of discount is critical-if high then fewer projects will be profitable (inflation also isnt accounted for)
give 2 advantages of using NPV
it correctly accounts for future earnings by calculating present values
the discount used can be changed as risk & market conditions change
what are some qualitative factors which will affect business choices?
-Human relations -> if choice could affect staff then may postpone plans
-Ethical consideration
-Risk ->the financial position the business is in, the state of the economy and the markets involved
-Availability of funds -> small business may struggle to raise investors and lendors
-Business confidence -> risk takers or shy managers?
