3.8 Flashcards
what is investment appraisal?
Investment appraisal refers to the quantitative techniques used to calculate the financial costs and benefits of an investment decision.
It aims to establish if it is worth pursuing a particular business and if it will be profitable
It also helps the business to compare different investment projects.
what is the pay back period?
a formula that estimates the period of time for an investment project to earn enough profits to repay the cost of the initial investment.
what is the formula for the pay back period?
initial investment cost
annual cash flow from investment
what is the general rule for payback period?
As a general rule the shorter the payback period the better it is for the firm.
what is the internal payback period?
The firm will decide an “internal” payback period that an investment should not go below
what are the advantages of the pay back period?
Simple calculation that tells the firm whether an investment will meet its cost.
super helpful in indutries where product become outdated fast
Easy method to compare with other investments.
Time focused which is especially important for companies that have liquidity problems.
Focuses on short term which is when forecasts are more likely to be correct
what are the disadvantages of the pay back period?
Focus is on time instead of return. This puts too much focus on short term goals.
Does not consider external factor that might affect demand, which could affect the payback period.
what is the avrage rate of return?
Also know as the “Accounting rate of return” it measures the annual net return on an investment as a percentage of its capital cost.
Think of it as an intrest rate, and a business can compare ARR with the intrest rakes and banks to deside what to do with big sums of money.
where can you find the average rate of return formula?
in the formula booklet
what are the advantages of the rate of return?
Simple calculation that will show the profitability of an investment in a given period of time.
It makes use of all the cash flows in a business (unlike the PBP).
Easy metric to compare with other investments
what are the disadvantages of the rate of return?
Does not include time value of money.
It does not consider the timing of cash inflows. Two projects might have the same ARR but one could pay back quicker than the other.
IMPORTANT!
Don’t conclude that if something is “high risk” or “risky” the business should avoid it. This is not reflective of the real world where business often have to make decisions that have certain elements of “risk”.
The main decision is not whether to take the risk or not but whether the benefits of the risks outweigh the costs involved.
some times you are given cash inflow instead of returns for ARR, how would you get the returns/net cash flow?
by removing the costs from the cash inflow.
when you are given a PBP with multiple cash flows from investment, what method do you follow?
step one- draw a table with three colloms, years (starting from 0), annual cash flow and then cumulative cash flow. (just like you do in maths.)
step 2- find year when it becomes postive, this does not nesesaraly mean it is a postive number, just that when ou add the next years annual cash flow it biomes one.
step 3- follow slightly more complicated formula.
what is the complicated PBP formula?
extra cash flow required divided by annual cash flow of the following year, times by 12, add your answer to the year it went positive.
