3.8 Investment appraisal

Question 1

What is the “payback period”?

Answer 1

The payback period is a method of investment appraisal, used to calculate the estimated time it takes for the net cash flows (or contribution) of an investment project to recoup the initial costs of the investment expenditure.

Question 2

What are some advantages of a “payback period”?

Answer 2

• It is the easiest and fastest method to calculate investment appraisal.
• The results are easy to understand.
• It is useful for businesses that suffer from cash flow problems, such as small sole traders, or those trying to survive a recession.
• It is also suitable for businesses in fast-changing industries, where products and trends can become outdated quite quickly.
• It aids decision making, as managers will tend to choose the investments with a short PBP in order to reduce risks.

Question 3

What are some disadvantages of a “payback period”?

Answer 3

• It does not take into account the timing of cash flows and contributions to profit
• The PBP method of investment is not usually suitable for determining long-term projects with a long PBP, as this increasing the risks of an investment project.
• There is no consideration of the potential net benefits after the PBP. For example, the useful life of the investment project is not considered by the PBP.
• For most businesses, profit is the main goal. The PBP does not reveal the profitability of an investment, but focuses instead on the length of time needed to recoup the costs of the project. Hence, the PBP a potentially highly profitable investment project could be overlooked as it has a longer payback period.

Question 4

What is “Average Rate of Return” (ARR)?

Answer 4

Due to some limitations of the payback period, we use the average rate of return to analyse the investment options and it considers the entire positive contributions/net cash flows even after the payback period is over.
–> This helping make judgements about the profitability of the investment option.

Question 5

What is the calculation of the ARR?

Answer 5

Average annual profit = ( Add all net cash flow - Initial Investment Cost ) / Number of years

( Average annual profit / Initial investment cost ) x 100

Question 6

What is “Net Present Value”?

Answer 6

The net present value is a method of investment appraisal that calculates the real value of an investment project by discounting the actual value of money received in the future.

Question 7

How do you calculate “Net Present Values”?

Answer 7

NPV = Sum of present values - Cost of investment
–> If NPV is positive, then the investment is worthy of risk and time

Sum of present values:
PV = FV x [ 1 / (1 + r) n ]