decision - making techniques Flashcards
investment appraisal
the process of using forecast cash flows to assess the financial attractiveness of an investment decision, linked with a consideration of non-financial factors
three methods of investment appraisal
- payback period
- average rate of return (ARR)
- net present value (NPV)
payback period
assessing the period of time a business must wait until its initial investment has been recovered
why can the payback period help a business
allows a firm to prioritise risk reduction when making investment decisions
payback period calculation
payback occurs when the CUMULATIVE cash flow reaches zero
FORMULA: (amount needed / next amount ) x 12
is it better to have quicker or longer payback
it calculates the length of time that the money is invested at risk, therefore quicker payback is best, however it may not always turn out to be most profitable in the long term
average rate of return
this method considers the profit generated by an investment
average rate of return Calculation (3 steps)
1 - calculate total profit over the lifetime of the project by adding all the net cash flows and deducting the initial outlay
2 - divide by the number of years the project lasts
3 - formula: (average annual profit / initial outlay) x100
what does a higher ARR mean
the higher the ARR the more profitable the investment
Net present value (NPV) using discounted cash flows
money tied up in an investment has an opportunity cost. This can be accounted for by discounting the value of future cash flows to allow for a given percentage return that could be achieved if the money were available now
Time value of money
The time value of money is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity through investment and other factors such as inflation expectations.
NPV calculation
each years net cash flow is multiplied by the relevant discount factor.
These are then totalled to give the overall NPV of the project
what does a positive NPV mean
that a project generates a greater return on its initial outlay than putting money in the bank at an interest rate equal to the percentage discount factor used.
Higher figure = more profitable it will be
strengths of using payback
- easy to calculate
- may be more accurate as it ignores long-term forecasts
- takes into account the timing of cash flow
- useful for a business with weak cash flow
limitations of using payback
- tells us nothing about profitability
- ignores what happens once payback achieved
- may encourage short termism attitude
strengths of using ARR
- clear focus on profitability
- considers cash flows over the whole projects lifetime
- easy to compare with other measures of return expressed as percentages (interest rates)
limitations of using ARR
- ignores cash flow timing
- values far distant inflows as more immediate inflow
- including forecast data from far in the future may reduce the reliability
strengths of using NPV
- takes opportunity cost of money into account
- considers both amount and timing of cash flows to indicate profitability
limitations of using NPV
- complex to calculate
- meaning is often misunderstood
- only comparable between different projects if the initial outlay is the same
other non financial factors to consider that may affect investment decisions
- corporate objectives (does investment focus on firm aims)
- company finances (expensive investments place firms financial health at risk)
- confidence in data (its always worth considering accuracy of data)
- social responsibility (some businesses may proceed in a project that may not be most financially attractive because it meets their social responsibilities
typical investment appraisal targets
- Payback in 3 years (depends on investment size)
- ARR of at least 15%
- Positive NPV using 10% discount factors
