3.3.2 Investment Appraisal Flashcards
What does investment appraisal involve?
- Involves comparing the expected future cash flows of an investment with the initial outlay (cost) for that investment
business may want to analyse how soon the investment will recoup the initial outlay or how profitable the investment will be.
What are the different methods used to appraise the value of an investment?
- Simple payback period
- Average Rate of Return
- Net present value of discounted cash flow
What is the simple payback period?
- A calculation of the amount of time it is expected an investment will take to pay for itself
How do you work out payback?
- Work out net cash flow for each year (inflow-outflows)
- Arrange it into a table with the cost of the investment at the top in brackets
- Then working down- work out the cumulative cashflow for each year
- You do this by adding on the net cashflow to the cost of the investment first.
- (This will give you a minus number initially)
- You then keep adding the net cashflow year on year until you have covered the cost of the investment
- It is in this year the payback occurs
- However, it may not fall on a exact year & instead happen during a year
- For this you then need to work out the number of months
- Take the net cash flow of that year divid it by 12
- Then take the amount of money you have left to pay & divide it by this amouny (the monthly cashflow)
- This result will then give you the number of months.
What are the benefits and drawbacks of using the payback method?
Benefits:
- Simple method to calculate and understand
- It is particularly useful for businesses where the cashflow management is vital
- Businesses can identify the point at which the investment is paid back & contributing to positive cashflow
- Focuses on liquidity- helps a firm recover their investment quickly reducing risk
- Businesses purchasing equipment can calculate whether an investment ‘pays back’ before an upgrade is available
Drawbacks:
- It provides no insight to the into the profitability of investments
- it may encourage a short-termism approach
- Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives
What is the average rate of return?
- AAR compares the average profit per year generated by an investment with the value of an initial outlay
What is the formula for average rate of return?
- Average Annual Return (AAR)/ Initial Outlay x100
What are the advantages and disadvantages of average rate of return?
Advantages:
- It considers all of the net cash flows generated by an investment over time
- It considers the entire project life span & doesn’t just stop like payback
- It is easy to understand & compare the % returns with each other
Disadvantages:
- As it depends on average cash flow, it ignores the timings of those cash flows
- The opportunity cost of the investment is ignored as values are nether expressed in real terms nor adjustments made for the impact of interest rates and time
- Doesnt account for time
- No risk adjustment- higher ARR doesnt necessarily mean better investment if project is risky
What is net present value (NPV)?
- A financial metric used to evaluate the value of an investment or a project
- The NPV of a project takes into account the effects of interest rates and time
- If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile but if it is positive then it is likely to be worthwhile
What does NPV represent?
- Net Present Value (NPV) is a financial metric used to evaluate the value of an investment or a project
- The NPV of an investment takes into account the effects of interest rates & time
It represents the present value of the future cash inflows minus the present value of the future cash outflows
- This discounting method takes into account the fact that that money received in future is worth less than money received today due to inflation
Give an analysis chain for NPV.
- A NPV indicates that a project is expected to generate more value over time, making it a more attractive investment.
- NPV accounts for both future cash inflows & the time value of money by discounting future earnings. A higher NPV suggests that the project will bring in significantly greater profits after covering the initial investment.
- If a business selects a project w a high NPV, it ensures greater long-term profitability, allowing for higher retained earnings, which can then be reinvested into further expansion, new product development, or improving operational efficiency.
- With stronger financial performance from the higher NPV project, the business may be in a position to increase dividends for shareholders or improve liquidity, reducing reliance on external borrowing. This can also strengthen investor confidence, leading to easier access to finance in the future.
What are the advantages & disadvantages of NPV?
Advantages:
- It considers the opportuity cost of money
- Discount tables are used to calculate forecast future values of net cashflows
Disadvantages:
- It is more complicated to calculate and interpret than other methods of investment appraisal
- One of the primary challenges of using the NPV method is accurately forecasting future cash flows
- The NPV method only considers the financial costs and benefits of a project and does not account for non-financial benefits or costs, e.g. environmental damage
What are the limitations of the investment appraisal techniques?
- Each of the investment appraisal techniques relies upon forecasted future cash flows which may lack accuracy
Managers compiling cash flow forecasts may lack experience or may be biased towards a particular investment
Long-term cash flow forecasts can be inaccurate for several reasons:
- Unexpected increases in costs
- The arrival of new competitors
- Changes in consumer tastes
- Uncertainties due to economic growth or recession
