6. Investment Appraisal

Question 1

Payback period

Answer 1

Assumes cash inflows occur evenly during the year.
= Initial Investment / Annual cash inflow (multiply the decimal by 12 to return the number of months).

Adv:

• Simple concept
• Favours projects with a quick return
• Argued that rapid payback reduces liquidity problems
• Uses cashflow to calculate which is more objective than profit.

Disadv:

• Project returns may be ignored as the calculation does not take into account cashflows after the payback period.
• Timing is ignored - cashflows are simply determined by pre-payback or post-payback. in particular the time-value of money is ignored which can be overcome by using the discounted payback method.
• Project profitability is ignored, it does not take into account the impact on business profits and the periodic performance of the project.
• There is no objective measure as to what length of time is an appropriate payback period. Therefore investment decisions are primarily subjective.

Question 2

Accounting rate of return (ARR) - LEARN

Answer 2

ARR calculates a percentage return provided by the accounting profits of the project.
Average annual profit / Average value of investment

Average Annual Profit = Net cash flow - Depreciation / number of periods.

Average value of investment
= Initial investment + residual value / 2

Question 3

Dealing with Inflation

Answer 3

Real rate of return
(1+r) = (1+m) / (1+i)
m = cost of capital / interest rate.
i = Inflation rate.