3.8 - Investment Apprasil Flashcards
Define investment
Purchase of an asset that will potentially generate future assets
Define investment appraisal
Quantitative technique used to evaluate the pros and cons of investment opportunities
What are the 3 tools to evaluate an investment
PBP
ARR
NPV
Define pay back period
The length of time required for an investment to recover its initial cost in terms of profit
Within PBP when do you know an asset is not worth purchasing
When it become obsolete before PBP
What is the formula for PBP
PBP = initial investment cost/cash flow from investment per period x 12 + number of years
What are the steps to solving NPV
- Make a table with 3 columns, 1 with year, one with net cash flow, one with cumulative net cash flow
- Minus the figure form year 0 and 1 and place that figure in cumulative net cash flow year 1 and continue
- Take the year in which that last negative cumulative cash flow occurred, that figure and then the following years net cash flow
- Place these figures into the formula: PBP = initial cash inflow needed/ anual cash flow in next year x 12 months (+number of years)
What are the positive of PBP
- simple, easy and quick
- quick way to check viability of investment project or complace investment opportunities
What are the negatives of PBP
- only takes time into account, overall project profitability is ingnored
- prediction = too simplistic
Define average rate of return
Average profit on investment expressed as % of initial investment (capital cost)
Define criterion rate
Internal benchmark for acceptance of investment project
What is the equation for ARR
ARR = (total return - capital costs) / years of use / Capital costs x 100
Pizza oven XYZ is worth 5000. The expected returns for 5 years of its lifespan are 3000, 2500, 2000, 1500, 1000. Calculate the ARR
Total returns = 10,000, ARR = (10000-5000) / 5 / 5000 x 100 = 20% (then ARR is compared to criterion rate and interests rate and investment appraisal is made)
What are the positives of ARR
- simple, easy and quick
- takes account of profitability for entire lifespan
What are the negatives of ARR
- ignores timings for return
- just a prediction
- to simple
Define NPV
Different between present values of future cash flows and original cost of investment
What is the formula for NPV
NPV = sum of present value - original cost
Define present value
Todays value of futre cash
What do you have to use when calculating NPV
Discount factor table
How do you calculate present value
Discount factor x predicated value = present value
What are the steps to calculate NPV
- Create a table with year, net cash flow, discount facto, present value
- Times net cash flow and discount factor to get present value
- Add up present value and minus the initial investment to get the NPV
- If value is positive the investment is worth pursuing
What are the positives of NPV
- includes both time and cash value
- flexible : discount factor may be altered along with state of economy
- takes into account many factos
What are the negatives of NPV
- more difficult to calculate
- inaccurate: unlikely intrest will be constant throughout project lifespan
- too simplistic to be only tool to rely on
