3.3.2 Investment appraisal Flashcards
What are the methods of investment appraisal?
1) Payback
2) Average rate of return
3) Net present value
What is payback?
A method of measuring how quickly the cost of the investment can be recouped
What is year 0?
The year of initial investment
How do you work out payback?
By acknowledging the initial investment then calculate how long it takes to get the investment back.
How should you leave the answer for payback?
1) a.b years
2) a years and b months
How should you work out the number of months?
multiply the decimal by 12.
How should you round your answer?
round the decimal to the next month
What is important to remember about investment appraisal techniques?
You should never make a decision based on payback method
What does investment appraisal do?
minimises risk
What type of capital can be shown in a table for investment appraisal?
1) inflows and outflows
2) net cash flow
What are the positives and negatives of using payback?
+ quick and simple, appropriate when liquidity issues arise (debts paid back), valuable assessment on risk
- predicted figures, short-termist, can’t look far into the future and the long-term, doesn’ t take into account the changes in the value of money.
What is average rate of return?
The annual percentage return on an investment project based on average returns earned by the project.
What is the desired payback?
the quicker the payback period the better
What is the desired average rate of return?
the higher the figure the better
How do you work out average rate of return?
(average rate of return/initial outlay) x 100
How do you work out annual profit?
(calculate total net over years - initial investment) / number of years
What do you do once you have calculated the investment appraisal value?
compare it with the targets?
What are the positives of using average rate of return as a decision-making tool?
forecasts future returns, simple and quick, minimises risk, easy to compare with other methods of investment appraisal
What can you easily compare average rate of return to?
interest rates in banks
What are the negatives of using average rate of return as a decision-making tool?
only a prediction, doesn’t take into account external factors, doesn’t adjust for time-value of money
What is net present value?
a method of investment appraisal that takes into account the value of money over time using a discounted cash flow.
Why is important to take into account the value of money over time?
Because a fixed sum paid in the future is less than a fixed sum today. Therefore, this minimises risk.
How do you work out net present value?
1) Multiply cash flow figure by the discount factor
2) = discounted cash flow
3) add up all discounted cash flow
4) - initial cost of investment
5) = NPV
What does the net present value need to be in order to be viable?
positive
What does the net present value need to be for a bad investment?
negative
What is the discount factor based on?
inflation rates (if high = high discount factor)
