5.9. Investment appraisal Flashcards
Define investment appraisal
Evaluating the profitability or desirability of an investment project
Assess whether the likely future returns on project will be greater than the costs and by how much
Information needed to be able to undertake a quantitative investment appraisal
- Initial capital costs of the investment
- Estimated life expectancy
- The expected residual value (additional net returns from the sale of the asset at the end of its useful life)
- Forecasted net returns or net cash flows from the project (expected returns less running costs)
Methods of quantitative investment appraisal
- Payback period
- Average rate of return
- Net present value
- Internal rate of return
- Discounted payback
Define payback period
The payback period is the length of time it takes for net cash inflows to pay back the original capital costs of the investment.
additional net cash flow needed x 12 / annual cash flow in the year that additional cash flow is needed
Why is payback period important?
- A business may have borrowed the finance for the investment => longer payback period will increase interest payments
- Even if the finance was obtained internally, the capital has an opportunity cost => the speedier the payback, the quicker the capital is made available for other projects
- The longer the project continues, the more uncertain it becomes since changes in the environment is difficult to manage
- Some managers are risk averse => quick payback reducs uncertainties
- Cash flows received in the future have less real value than cash flows today due to inflation. The quicker, the higher the real value will be
Advantages of payback period
- It is quick and easy to calculate
- Easily understood
- Emphasis on speed of return gives the benefit of concentrating on the more accurate short term forecast of the project’s profitability
- Result can be used to screen out projects that aren’t feasible
- Useful for business where liquidity > profitability
Disadvantages of payback period
- Does not measure the overall profitability of a project as it ignores all the cash flows after the payback period. It may be possible for an investment to give a rapid return of capital, but then to offer no other cash inflows
- Concentration on short term may lead to businesses to reject profitable long term investments
- Does not consider the timing of the cash flows during the payback period
Define average rate of return
The average rate of return (ARR) measures the annual profitability of an investment as a percentage of the initial investment.
- add all up positive cash flows
- Subtract cost of investment
- Divide by life span
- x 100
Advantages of ARR
- Uses all of the cash flows
- Focuses on profitability
- Easily understood
- Easy to compare
- Can be quickly assessed against criterion rate
Disadvantages of ARR
- Ignores the timing of the cash flows => result in 2 projects having similar ARR results, but one could pay back much quickly than the other
- As all cash flows are included the later ones are less likely to be accurate
- Time value of money is ignored as the cash flows have not been discounted
Define net present value
The net present value (NPV) measures today’s value of the estimated cash flows resulting from an investment.
- multiply discount factors by the net cash flows
- add the discounted cash flows
- subtract the capital cost/original investment
Advantages of NPV
- It considers both the timing of cash flows and the size of them in arriving at an appraisal
- The rate of discount can be varied to allow for different economic circumstances. e.g. could be increased if there was a general expectation that interest rates were about to rise
- It considers the time value of money and takes the opportunity cost of money into account
Disadvantages of NPV
- Reasonably complex to calculate and explain
- Final result depends greatly on the rate of discount used and expectations abt interest rates may be inaccurate
- NPV can be compared with other projects but only if the initial capital cost is the same. This is because the method does not provide a % rate of return on investment
Define internal rate of return
the rate of discount that yields a NPV of zero
the higher the IRR, the more profitable the investment project is
What should IRR be compared with?
- the IRR of other projects - the highest reflects the most profitable investment
- the expected cost of capital or rate of interest and if IRR is greater, the project should be profitablem taking the cost of borrowed capital into account
- a cut-off rate or criterion rate of return preset by the business
