Business 3.8 Flashcards
What is paypack period
investment appraisal method that considers the time (in months or years) it takes for the amount of money invested in a project to be repaid using the proceeds generated from the investment.
What is investment appraisal
quantitative techniques that are used to evaluate the advantages and disadvantages of investment opportunities.
How to construct payback period table
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Advantage of paypack period
- Simple and quick method.
- Helpful for industries where assets quickly become outdated (eg: tech)
- Useful for companies faced by cash flow problems as it helps them identify how long it would take investment to be recouped.
- Gauge whether can break-even on the purchase of an asset, important in today’s fast paced and competitive environment.
- Compare different investment projects and make best decision.
- Managers can assess projects that will yield quick return for shareholders.
Disadvantage of paypack period
- Ignores long-term profitability of an investment, encourages mostly short-termism approach to investment and neglect long-term considerations.
- Predictions.
- Too simplistic to be the only tool to rely on and can be quite prone to errors.
- May not be suitable for businesses who may need a long time to recoup their investments.
What is average rate of return
method of investment appraisal calculates the average annual profit of an investment project expressed as a percentage of initial investment.
How to calculate ARR
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Advantages of ARR
- Simple, easy, quick to calculate
- Takes account of profitability for the entire lifespan.
- Easiest and quickest way to compare viability of investments.
Disadvantage of ARR
- Ignores timing of the NCF. Prone to forecasting errors.
- Total returns and lifespan are predicted.
- Time-based forecasts errors: Errors are more likely the longer the time period under consideration.
What is net present value
method of investment appraisal that calculates the difference between present and future values of future cash flows and original cost of investment.
Detailed steps to calculating NPV
- Write down the years.
- Write down the net cash flow for each year.
- Copy down discount factor.
- Multiply each NCF by the discount factor.
- Add all present values together.
- Apply the formula!!!
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Benefits of investment appraisal
- Considers the change in value of money over time.
- Compare opportunities with different investment periods limitations.
Limitation of investment appraisal
- Inaccurate: Assume value of money remains stagnant, assumes future value of money.
- More complex to calculate than PBP and ARR.
- Results are only comparable if the initial investment cost is the same between competing projects.
- Inflation: Present discount rate fluctuates depending on future economic conditions.
- Too simplistic tool to rely on.
Evaluation of investment appraisal
If business is prioritising profits, then should choose investments with short PBP, higher ARR or NPV.
Evaluation Payback Period:
Useful for projects with a need for quick liquidity and a clear desire for a short-term return. It may be appropriate for projects where the primary concern is the recovery of the initial investment within a specific time frame.
