3.3.2 Investment Appraisal Flashcards
What is investment appraisal?
How a business objectively evaluates an investment decision in order to establish if it will be profitable.
What are the three main methods available to a business?
Simple payback
ARR (average/annual rate of return)
Discounted cash flow (net present value)
What is the payback method?
The payback method calculates the length of time it takes for an investment to recoup its original cost.
What are the pros and cons of the payback method?
Pros:
- Simple to use and easy to understand
- Quick and easy to calculate
- Focuses on cash flow and the speed of return
- Helps assess the viability projects with a short life cycle
- A quick method of screening potential investments
Cons:
- Takes no account of overall profitability
- Ignores the time value of money
- Encourages short term thinking
- Doesn’t help to pick between two projects with the same payback period
What is ARR?
ARR measures the net return each year as a percentage of the capital cost of investment.
What are the positives of ARR?
Clearly shows the profitability of a project
Allows a range of projects to be compared
The overall rate of return can be compared to other uses of the investment fund
What are the drawbacks of ARR?
The effects of time on the value of money are ignored.
What is NPV?
Takes interest rates into account by calculating the present value of future income.
What are the advantages of NPV?
Present values are calculated (Present value = Expected outcome x discount factor)
Discount rates used can be changed as risk and conditions in financial markets change.
What are the limitations of NPV?
Calculations are more complex than other methods.
If the discount rate applied needs to be accurate, if it is too high projects are unlikely to appear profitable.
