3.7.8 Analysing strategic options: investment appraisal Flashcards
What is investment appraisal?
the process of analysing whether investment projects are worthwhile
What are the financial methods of assessing investment?
- Payback
- Average rate of return
- Net present value (NPV)
Explain what investment is and why businesses invest
Investment is the process of purchasing non current assets like buildings and machinery
Investment considers the buying of an asset that will pay for itself over a period of more than one year
It is done to replace and renew assets, and to introduce additional assets
What is payback?
- The length of time it takes for an investment to recover the initial expenditure (usually measured in months or years)
- It focuses on cash flow and looks at a cumulative cash flow of the investment up to the point which the original investment has been recouped from the investment cash flow
What is the formula for payback?
Amount invested/Annual net return
What are the advantages of payback?
- Simple and easy to calculate, and easy to understand the results
- Focuses on cash flows – good for use by businesses where cash is a scarce resource
- Emphasises speed of return; may be appropriate for businesses subject to significant market change
- Straightforward to compare competing projects
What are the disadvantages of payback?
Ignores cash flows which arise after the payback has been reached (i.e. does not look at the overall project return)
Takes no account of the time value of money
May encourage short-term thinking
Ignores qualitative aspects of a decision
Does not actually create a decision for the investment
What is the Average Rate of Return?
the total net returns divided by the expected lifetime of the investment, expressed as a % of the initial cost of investment
Why is average rate of return important to business investment projects?
Business investment projects need to earn a satisfactory rate of return if they are to justify their allocation of scarce capital – the ARR looks at the total accounting return for a project to see if it meets the target return
What are the advantages of average rate of return?
ARR provides a percentage return which can be compared with a target return
ARR looks at the whole profitability of the project
Focuses on profitability – a key issue for shareholders
What are the disadvantages of ARR?
Does not take into account cash flows – only profits (they may not be the same thing)
Takes no account of the time value of money
Treats profits arising late in the project in the same way as those which might arise early
What is Net Present Value?
this compares the amount invested today to the present value of the further cash receipts from the investment
It reflects the time value of money by discounting the value of future cash flow
What are the advantages of NPV?
Takes account of time value of money, placing emphasis on earlier cash flows
Looks at all the cash flows involved through the life of the project
Use of discounting reduces the impact of long-term, less likely cash flows
Has a decision-making mechanism – reject projects with negative NPV
What are the disadvantages of NPV?
More complicated method – users may find it hard to understand
Difficult to select the most appropriate discount rate – may lead to good projects being rejected
The NPV calculation is very sensitive to the initial investment cost
What are the characteristics of capital investment decisions?
Involves long terms commitment of capital sums
Benefits are received as a stream stretching long into the future
They are almost impossible to reverse without accepting a significant loss
Contain an element of uncertainty
Costs are incurred today but benefit in the future
They affect future probability and the firms very existence
