3.8 Investment appraisal Flashcards
What is meant by investment?
Investment refers to the purchase of an asset with the potential to yield future financial benefits
What is investment appraisal?
Investment appraisal refers to the quantitative techniques used to calculate the financial costs and benefits of an investment decision
What is the payback period and how is it calculated?
The payback period (PBP) refers to the amount of time needed for an investment project to earn enough profit to repay the initial cost of the investment.
PBP = Initial investment cost ($)/Contribution per month ($)
State the benefits and drawbacks of the payback period as a method of investment appraisal.
ads:
- simplest and quickest method
- useful for firms with cashflow problems
- allows a firm to see whether it will break-even
- assess projects
disads:
- contribution per month is not constant
- PBP focuses on time as a key criterion for investment
- encourage short-termism
- not suitable for some firms
- calculations are prone to errors
What is the average rate of return and how is it calculated?
The average rate of return (ARR) calculates the average profit on an investment project as a percentage of the amount invested.
Total profit during project’s lifespan {$)/number of years of project
/
Initial amount invested ($)
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What is meant by a discount factor? [HL only]
A discount factor is used to convert the future net cash flow to its present value today.
What is net present value and how is it calculated? [HL only]
The net present value (NPV) is the sum of all discounted cash flows minus the cost of a particular investment project.
NPV = Sum of present values - Cost of Investment
What are the advantages of the ARR and NPV over the payback period as methods of investment appraisal?
ARR and NPV consider how the value of money changes over time.
