3.8 Investment appraisal Flashcards
Definition of investment appraisal
formal process of quantifying the financial risks of an investment decision. It helps to determine if a capital investment project is worthwhile, by examining the costs of the investment and the expected return on investment.
What are the two investment appraisals
- payback period (PBP)
- average rate of return (ARR)
Payback period
it refers to the amount of time needed for an investment project to earn enough profits to repay the initial cost of the investment.
Formula of pay back period
Cost of investment / Contribution per month
Advantages of pay back period (5)
-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-It is also suitable for businesses in fast-changing industries, where products and trends can become outdated quite quickly.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.
Disadvantages of payback period (4)
-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.
Average rate of return
calculates the average profit on an investment project expressed as a percentage of the amount invested.
Formula for Average rate of return (2)
((total cost - capital cost)/ years of use) / capital cost x 100
Average annual profit / Initial investment cost x 100
Advantages of the average rate of return (ARR) (4)
-It is relatively straightforward to calculate, and easy for people to understand.
-Unlike the PBP (payback period), the ARR focuses on the profits of a particular project, rather than length of time it takes for a project to pay for itself.
-The ARR can be used by managers and decision-makers to judge or evaluate the firm’s financial performance.
-The methods can be useful to help managers, shareholders and other decision makers to compare the relative attractiveness of different investment projects that cost different amounts of money (as the ARR figure is expressed as a percentage of the initial costs).
Disadvantages of the average rate of return (ARR) (3)
-The ARR ignores the timings of future net cash flows, so money received in the future is worth less than it would be if received today. This means the ARR may overestimate the real or true value of the financial returns on an investment.
-The ARR focuses on profits (which are not estimates at best, and not entirely received until the distant future), rather than on cash flow (which is the ‘lifeblood’ of the business). Irrespective of the forecast ARR, without sufficient cash flow, the business will not survive).
T-he figures used to calculate the ARR are only estimates, so the results or forecasts need to be treated with some caution. The longer the investment project under consideration, the less accurate the forecasts will be; we might know what we have planned to do tomorrow or next week, but less certain about this for 5 or 10 years’ time.
