7 - Investment Appraisal Flashcards
What Is Investment Appraisal?
Process of seeing whether investment projects are worthwhile and profitable.
What Are The 3 Main Methods Of Investment Appraisal?
~ Payback period.
~ Average rate of return (ARR).
~ Net present value (NPV).
What Is The Payback Period?
The time it takes for a project, to repay its initial investment.
What Are The Outcomes Of Payback Period?
Time. E.g. X years, Y months.
How Do You Calculate Payback?
(2 Points)
~ Calculate which year the investment will be payed back, when the value turns from negative to positive.
~ Calculate months added on to the year left to payback.
In Payback, How Do You Calculate The Year In Which The Investment Is Payed Back?
(3 Points)
~ Firstly, add the initial investment cost to the net inflows of year 1. E.g. -100 + 40 = -60.
~ Add the payback from the previous year and add it to the net inflows of the current year. E.g. -60 + 40 = -20.
~ The year the value turn positive, is when the payback is payed. E.g. End of year 3 payback was +60, meaning somewhere between year 2 and year 3 was when it was payed.
In Payback, How Do You Calculate The Months Left To Payback?
(2 Points)
~ Take how much you had left going into the year it turned positive and divide it by the value of inflow of the positive year. E.g. 20/50 = 0.4.
~ Convert the decimal into months by multiplying the value by 12. E.g. 0.4 x 12 = 4.8 months.
Work Out The Payback Of This Project?
3 years, 3 months.
What Are The Benefits Of Using Payback Period?
(4 Points)
~ Simple and easy to calculate, easy to understand the results.
~ Informs managers of the speed the project will be payed back in.
~ Straightforward to compare competing projects.
~ Focuses on cash flows.
What Are The Drawbacks Of Using Payback Period?
(3 Points)
~ Does not take into account overall returns like ARR and NPV.
~ Does not adjust for time value of money like NPV.
~ Ignores cash flows after payback has been reached.
What Is Average Rate Of Return (ARR)?
Calculates the average profit as a percentage of the cost of the initial investment.
What Is The Formula For ARR?
Average Net Return (£) / Initial Cost Of Project (£) x 100.
For ARR, If The ARR Is Higher Than The Target, What Will Happen?
Would be accepted, the higher the better.
How Do You Calculate ARR?
(3 Points)
~ Calculate the average net return.
~ Divide the average net return by the initial investment / cost of project.
~ Compare the ARR with the target percentage return.
For ARR, How Do You Calculate The Average Net Return?
(4 Points)
~ Total Net Cash Flow / No Of Years.
~ Add all the net inflows for every year. E.g. -100 + 40 + 40 + 50 + 10 = 40.
~ Find the amount of years. E.g. 4 years.
~ 40 / 4 = 10.
For ARR, How Do You Calculate The Actual ARR Figure?
(3 Points)
~ Average Net Return / Initial Investment.
~ 10 / 100 = 0.1.
~ 0.1 x 100 = 10% -> ARR of project 1.
Work Out The ARR Of Project 2
ARR = 15%.
What Are The Benefits Of Using ARR?
(4 Points)
~ Considers the total returns of the project, unlike payback.
~ Easy to compare to other projects, unlike payback.
~ Simple to understand and easy to calculate.
~ Focuses on the overall profitability of an investment project, benefits shareholders.
What Are The Drawbacks Of Using ARR?
(3 Points)
~ Ignores the timings of returns.
~ Focuses on profits rather than cash flows.
~ Does not adjust for time value of money, unlike NPV.
What Is Net Present Value (NPV)?
Calculates the total return on an investment, taking into account the time value of money.
What Is Discounting?
Method used to reduce the future value of cash flows to reflect the risk that they may not happen.
How Do You Calculate The Present Value Of A Future Cash Flow?
Cash Flow x Discount Factor.
What Is The NPV Decision?
(3 Points)
~ Accept the project = Positive NPV.
~ Reject the project = Negative NPV.
~ The higher the NPV the better.
How Do You Calculate NPV?
(2 Points)
~ Multiply the expected return (Net flows) by the relevant discount factor to give you the present value (PV).
~ Add all the present values, to get the NPV.
