Fiance Management 9 Flashcards
four methods to evaluate business opportunities
accounting rate of return (ARR)
payback period
net present value
internal rate of return
what is accounting rate of return
method takes the average accounting operating profit that an investment will generate and expresses it as a percentage of the average investment made over the life of the project
ARR equation
average expected return (accounting profit)/ average capital employed (investment) *100%
average capital employed =
(initial capital outlay + proceed/disposal value at the end)/2
pros of ARR
simple and easy to calculate easy to understand
very similar to return on capital employed seen as key ratio by investors
projects judged by ARR are assessed internally in the same way as assessed internally
cons of ARR
attaches same value to cash flows whether received in year 1 or year 5
(should ARR be calculated before or after depreciation)
doesnt consider size of investment, investment of £400 with 10% generates £4, investment of £4000, £40
what is the payback period
length of time it takes for an initial investment to be repaid out of the net cash inflows from a project
why would a business choose a project with quick payback
further in the future, harder to estimate cash flows, therefore reduces the risk involved in estimate and so funds are available for a new project
pros of payback
minimises impact of long term risk
quick and simple to calculate and managers easily understand
avoids obvious difficulties in projecting cash flow several years from hence
negatives of payback
ignores time value of money
favours short term project over long term projects
difficulties in predicting when expenditure has to be paid, especially when large negative cash flow at the end of the project is present
how do you compound money
you have money value of x * (1+r)^n where r is your interest rate and n the number of years
how do you discount money
you have money value of x * (1+r)^-n where r is your discount rate and n the number of periods
what is discounting
when doing invesment appraisal use to take into account inflation but also the firms required rate of return
how will a higher risk companies rate of return and discount rate be affected
high risk - higher rate of return required - higher discount rate
discount rate for a business uses for investment appraisal is known as
its cost of capital
how is the rate of return calculated
opportunity cost of other projects, risk and inflation
how is net present value calculated
(investment) + discounted total cash flow
if an investment has a positive net present value
it should be accepted
benefits of NPV
recognises the time value of money,
recognises the difference in size of investmet
it allows for additivity - can combine NPVs of multiple dependent projects to calculate overall
weakness of NPV
difficult to explain to people not formally trained in finance
provides answer in monetary terms so does not allow comparison for profitability of the project
What is internal rate of return (IRR)
is the discount rate that when applied to its future cash flows will produce an NPV of zero, represents return from an investment opportunity
which is preferred NPV or IRR
NPV where net cash flows are both positives and negative there can be more than one IRR
business might be concerned with value of cash
why does all appraisal techniques consider cash flow not profit
as cash does not suffer from accounting allocations is a better predictor of future wealth
