7 - Investment Appraisal Flashcards
What Is Investment Appraisal?
Process of seeing whether investment projects are worthwhile.
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 Outcome 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, good liquidity measure.
~ Straightforward to compare competing projects.
~ Focuses on cash flows.
What Are The Drawbacks Of Using Payback Period?
(4 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.
~ Does not actually create a decision for the investment, or take into account what happens after payback.
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 Annual 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 annual return.
~ Divide the average annual return by the initial investment / cost of project.
~ Compare the ARR with the target percentage return.
For ARR, How Do You Calculate The Average Annual 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 Annual 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 there is no liquidity focus, unlike payback.
~ 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.
What Is Time Value Of Money (TVM)?
An identical sum of money is worth more today than it is in the future.
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?
~ 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.
For NPV, How Do You Calculate The Present Value?
(2 Points)
~ Net Flows x Discount Factor.
~ E.g. 40,000 x 0.91 = 36,400.
For NPV, How Do You Calculate The Net Present Value?
(2 Points)
~ Add all the present values, including the costs.
~ E.g. -100,000 + 36,400 + 41,500 + 45,600 = 23,500 -> NPV.
~ Accept the project as it is positive.
Work Out The NPV Of This Project
(2 Points)
~ 24.96 is the NPV.
~ Accept the project as the NPV is positive.
What Are The Benefits Of NPV?
(4 Points)
~ Takes into account the time value of money, unlike ARR and payback.
~ Easy to see if you should accept or reject the project, unlike payback.
~ Different levels of risk can be accounted for by adjusting the discount rate.
~ Considers all future cash flows.
What Are The Drawbacks Of NPV?
(2 Points)
~ The inflows are all estimates, like ARR and payback.
~ Interest rates can change the discount factor, therefore results can be influenced by this.
What Are Key Financial Factors Influencing Investment Decisions?
(3 Points)
~ Investment criteria.
~ Alternative investments.
~ Financial position of the business.
What Are Key Non-Financial Factors Influencing Investment Decisions?
(4 Points)
~ Corporate objectives.
~ Organisational culture.
~ Management confidence in investment appraisal data.
~ Business image and reputation.
What Is Investment Criteria?
Measures by which an investment will be judged.
