3.7.8 Analysing strategic options: investment appraisal Flashcards
What is investment appraisals?
The process of analysing whether investment projects are worthwhile.
What are the three financial methods of assessing investment?
- Payback
- Average rate of return (ARR)
- Net present balue (NPV)
Why should businesses invest?
- Investment is the process of purchasing non- current assets (building)
- Investment considers the buying of an asset that will pay for itself over a period of more than one year
- It replaces ad renews assets and to introduce additional assets
What is payback?
The length of time it takes for an investment to recover the initial expenditure.
What is the formula for payback?
Amount invested / Annual net return
What does payback focus on?
Cash flow and looks at cumulative cash flow of the investment until it has been recouped.
What are the advantages of payback?
- Simple and easy to calculate, and easy to understand the results
- Focuses on cash flow- good when cash is a scarce resource
- Straightforward to compare competing projects
- Emphasises speed of return- appropriate for significant market change
What are the disadvantages of payback?
- Ignores cash flow which arise after payback has been reached
- Takes no account of the time value of money
- May encourage short-term thinking
- Ignores qualitative aspects of decisions
- Does not actually create a decision for the investment
What is ARR?
The total net returns divided by the expected lifetime of the investment, expressed as a % of the initial cost of investment
What does ARR focus on?
It looks at the toal accounting return for a project to see if it meets the target return.
What is the formula for ARR?
((Total net profit / no Years) / Initial cost ) X 100
What are the advantages of ARR?
- Provides 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 profit
- Takes no account to the time value of money- inflation
- Treats profits arising late in the project in the same way as those which might arise early
What is a net present value (NPV)?
Compares the amount invested today to the present vaue of the further cash receipts from the investment.
What does NPV reflect?
Reflects the time value of money by discounting the value of future cash flow
What is the formula for NPV?
What are the advantages of NPV?
- Takes account of time value money, placing emphasis on earlier cash flows
- Looks at all the cash flows invloved through the life of the project
- Use of discounting reduces the impact of long-term, less likely cash flow
- Has a decision-making mechanism- rejects projects with negative NPV
What are the disadvantages of NPV?
- More complicated method- hard to understand
- Difficult to select the most appropriate discount rate- may lead to good projects rejected
- NPV calculation is sensitive to initial investment cost
Factors influencing investment decisions
What factors affect capital investment decisions?
- Interest rates
- Economic growth
- Confidence/expectations
- Technology development
- Availability of finance from banks
- Deprication, wage costs, inflation and government policy
What is sensitivity analysis?
- Allows key assumptions to be changed to analyse the effect
- Helps to judge the degree of risk
- Recognises there is no such thing as an accurate forecast
- Considers one varial/assumption at a time
What are the advantages of sensitivity analysis?
- Helps assess risks and prepare for less than favourable scenario
- Identifies the most significant assumptions
- Helps make precess of business forecasting more robust
What are the disadvantages of sensitivity analysis?
- Only tests one assumption at a time
- Only as good as the data which the forecast is based upon
- Complicated concept
