3.3.2 Investment Appraisal Flashcards
investment
spending now with the expectation of a return in the future
Capital investment
machinery and equipment that has a long term benefit
Revenue investment
spending on stock, wages that has a short-term benefit
Investment appraisal
a series of techniques designed to assist businesses in judging the desirability of investing in particular projects
What does investment include decisions on?
- introducing new products
- expansion
- new technology
- advertising campaigns
What is payback?
the length of time that it takes for an investment to pay for itself from the net returns provided by that particular investment
What is the payback formula?
number of full years + (what you need/what you get) x 12
Advantages of payback
- easy to calculate
- takes into account the cost of the investment
- focuses on short-term cash flow as a priority
Disadvantages of payback
- ignores the overall return on a project
- ignores the time-value of money
- encourages a short-term approach
Average rate of return
a method of investment appraisal which measures the net return per annum as a percentage of the initial spending
How to calculate ARR?
- calculate total profit
(total net cash flow - investment outlay) - average profit = total profit / number of years
- ARR= (average profit/ initial costs) x100
ARR advantages
- measures profitability
- easy to compare % returns against other investments
- considers total profit made
ARR disadvantages
- ignores the timings of cash flows
- ignores the time value of money
- ignores the risk that projections of future sales may be more inaccurate the further into the future they are
What is Net present value only?
the present value of future income from an investment appraisal
-takes into account time and the value of money
What is a discount factor (NPV)?
a discount factor is given to reduce the present value of a future income
-the discount factor takes into account the interest, or return the investment could have had if it has been put in the bank or spent on something else
3 steps for calculating the NPV
- multiply net cash flow x discount factor
- add up all the present values
- substrate the initial outlay
What is the formula for NPV?
NPV = total income - initial cost of investment
Advantages of NPV
- considers all cash flows
- use of discounting reduces the impact of long-term
- has a decision making mechanism - rejects projects with negative NPV
Disadvantages of NPV
- complex to calculate
- cannot compare projects with a different initial costs
- rate of discount is critical - if it is high, fewer projects will be profitable
