Chapter 9- Investment Appraisal Flashcards
What is investment appraisal?
A technique used to evaluate planned investment by a business and measure its potential value to the business
3 methods of investment appraisal
1) Payback period
2) Average rate of return (ARR)
3) Discounted cash flow (DCF)
What is payback period?
The time it takes for the project to pay back the initial outlay
The project with the SHORTEST payback period should be chosen
Example of payback period
If a project costs £20,000 and generates £10,000 each year, the payback period of the project would be 2 years
Advantages of using payback period
1) Simple to use
2) Easy to calculate
3) Effective to use when technology is changing at a fast rate in order to recover the cost of investment as quick as possible
4) Helps with managing cash flow
Disadvantages of using payback period
1) Ignores flows of cash over the lifetime of the project
2) Ignores total profitability, the focus is just on the speed to which the initial outlay is repaid
What is average rate of return (ARR)?
Measures the average net return every year with the cost of the investment. The ARR Is expressed as a percentage allowing for a straight forward comparison between different investment options.
The project with the HIGHEST ARR is chosen
How to calculate ARR?
1- Calculate total cumulative cash flow; then take away initial cost of the investment from net cash flow total
2- Calculate average profit per annum; dividing figures in stage 1 by the number of years the project runs for
3- Divide the average net cash flow per annum by the initial cost of the project, and multiply by 100
Formula for ARR
Average profit per annum/ Initial investment cost X100
Advantages of using ARR
1) Shows the profitability of the project
2) Includes all the projects cash flows
3) Easy to compare different projects
4) Allows comparison with costs of borrowing for investment
Disadvantages of using ARR
1) Ignores the timing of the cash flow
2) Does not allow for effects of inflation on values of future cash flows
What is discounted cash flow?
A method that takes into account the time value of money
The project with the HIGHEST net present value is chosen
How does DCF work?
It calculates the net present value (NPV) of alternative projects. The NPV if the value of future money if you had it now; it takes into account inflation and the potential for earning interest on investment capital
How to calculate DCF?
1- Use a discount figure (usually given by a bank)
2- Multiply the cash flow for each year by the discount factor for that year
3- Total the discounted cash flow to calculate the total present value
4- Calculate the net present value by subtracting the initial investment from the total present value
Advantages of using DCF and NPV
1) Allows for future earning to be adjusted to present values
2) Easy to compare different projects
3) Allows for impact of inflation on value of future cash flows
4) Discounts can be changed to take into account changes in the economic and financial climate
5) Allows for effect of risk on estimated future cash flows
Disadvantages of using DCF and NPV
1) It is difficult to calculate
2) Discount factors could be incorrect which makes the NPV inaccurate
3) Difficult to set discount factors far into the future, the longer into the future we go the less reliable the discount factor
Qualitative factors affecting investment appraisal decisions
1) Impact on staff; can they handle the changes of the investment
2) Does the investment match the strategy and objectives of the business?
3) Action of competitors; are they investing/ improving their products?
4) Availability of new technology
5) Confidence of managers; optimistic managers are more likely to invest
