3.8 Investment Appraisal Flashcards
payback period
time taken for a capital investment to pay for itself, by estimating future cashflow each year and working out the month and year in which the cashflow will finally cover the investment cost
calculating payback period
- calculate net cashflow for each year
- find cumulative cashflow (cashflow of previous year and cashflow of current year)
- find payback period
formula for payback period
(amount left to pay/ net cashflow that year) * 12
benefit of payack period method
simplicity
drawbacks of payback period method
- ignores long-term profitability of an investment
- more desirable investment may be overlooked as it has a longer payback period
- assumes future cash flows have same value of money in the future
average rate of return (ARR)
investment appraisal technique where annual forecast returns as a percentage of the initial capital cost
average rate of return formula
(((total returns - capital cost) / years of use) / capital cost) * 100
steps to calculate ARR
- calculate net cashflow over lifetime of investment minus capital cost
- divide resiult from step 1 by number of years of the project
- divide the result from step 2 by the project’s initial investment cost
- multiply by 100
ARR can also be seen as
investment profitability
inflation
increase in the general price level in the economy
what happens to the value of money over time
it decreases
net present value (NPV)
method of making investment appraisals more accurate by using a discount rate to adjust the value of future returns
discount rate
rate of return that a business could earn on another comparable investment
present value (single year) formula
net cash flow * discount factor
net present value (NPV) formula
sum of (presenta values of return - original cost)
steps to calculate NPV
- discount the net cash flows in each year
- find net present value
benefits of NPV
- considers the change in value of money over time
- allows business to compare opportunities with different investment appraisals
limitations of NPV
- more complex to calculate
- assumptions are made (inaccurate)
- discount rate can be inaccurate)
things to consider when buying expensive assets
- return on investment
- cost savings
- break-even
- market share
- financing
- cash flow assumptions
- mission statement
alternative ways to spend retained profits (not in investments)
- pay down debts to lower risk and interest payments
- pay dividends to their shareholders
- buy back shares of their own company to boost the stock price
