6. capital investment appraisal Flashcards
Why are investment decisions crucial?
- large amounts of resources are often involved (relative and absolute) but relative scale of investment varies from one business to another
- difficult and/or expensive to ‘bail out’ of an investment once undertaken, meaning:
levels of capital investment are often very high and for the sake of the business, need to be successful
What are the natures of investment decision?
- essential feature of investment decisions is the time factor
- economic outlay at one point and yield of economics benefits in future
- outlay is typically one large amount
- benefits typically arrive in a stream of smaller amounts
What are the 4 methods of investment appraisal?
- Accounting rate of return (ARR)
- payback period (PP)
- net present value (NPV)
- internal rate of return (IRR)
what is the formula for ARR?
ARR= (average annual profit after deepen)/average investment) x 100
what is the formula for average investment?
(initial investment + disposal value)/2
What are the advantages of ARR?
- measures profit: a good way of measuring business performance
- calculations are relatively simple and straightforward
- the entire life of the project is taken into account
what are the disadvantages of ARR?
- Uses profit rather than cash
- Advantages can be misleading
- different definitions of ARR can confuse
- takes no account of the time value of money
What is Payback Period?
- overcomes some of the timing problems associated with ARR
- it is the amount of time it takes for initial investment to be repaid out of the net cash inflows from the project - thus replenishing cash and helping avoid liquidity problems
- The quicker the cash paid out for the investment is received, the better, from a cash flow perspective and especially if the company’s liquidity is an issue
- figures represent amounts of cash to be paid out initially and then received. This is important because however profitable a business may be, it has to have cash or access to cash to survive
How to calculate payback period?
- Do a cumulative cash flows column (adding the net cash flows of each year but keeping year 0 the same)
- do a workings column where you add the previous year to the current and when it turns positive, e.g towards the end of the 3rd year, you would take the 2nd year and divide it by the 3rd year, multiply by 365 and add 2 years
what are the advantages of payback period?
- simple to calculate
- useful for risky projects
- short-term cash flows important to the company
- measure of liquidity
what are the disadvantages of payback period?
- sometimes cash flows in one year are given the same degree of importance as those in other years, there is no consideration of the time value of money
-PP method ignores cash flows after PP period, thus a quicker repaying project may be chosen over a slower repaying project, but the slower repaying project may ultimately be more profitable
(PROJECT WITH SHORTER PP WOULD NORMALLY BE SELECTED)
what method of appraisal is desirable?
That:
- takes account of all costs and benefits
- makes allowances for timings of costs and benefits
… and the NPV method provides this
What is the time value of money?
£100 paid out now is NOT equivalent to £100 received in a year’s time because:
-interest lost (opportunity cost)
- risk
- effects of inflation
