Investment appraisal

Question 1

Simple payback

Answer 1

Payback period- the amount of time it takes to recover the cost of investment project

Payback method is used to choose between projects/ the one with the shortest payback period.

To calculate:
1. Add a cumulative cash flow column next to each project, so that the cashflows each years are added together (add year 1 to 2, 2 to 3 etc..)

2. Find whether any of the cumulative cash flows are equal to the project cost. That would be the payback period.
3. If the project cost falls between two cashflows:
   3a. Find the two years that the payback falls between
   3b. Take the cumulative cashflow for the earlier year, away from the project cost. The figure remaining is the balance of the project cost left to pay off in the next year
   3c. Calculate the monthly cashflow for the later year by dividing the cashflow for the year by 12
   3d. Divide the answer in 3b by the answer in 3c to find the number of months into the year it will take to payback the remaining project cost
   3e. Add the months next to the year(s) and you have your answer

Question 2

Evaluation of payback method

Answer 2

Pros
Simple and easy to calculate
Easy to understand
Focuses on cashflow

Cons
Ignores cashflows which arise after payback has been reached
Ignores qualitative aspects of decision making
Encourages short-term thinking

Question 3

Average rate of return (ARR)

Answer 3

ARR measures the average annual percentage return the investment provides to the business. The project with the highest ARR is chosen

ARR= net return per annum/ cost x 100

To calculate:
1. Find the total of the net cash flows

2. Deduct the project cost from the net cash flows
3. Divide the answer by the number of years the project is expected to last to find the average net cashflow per annum
4. Divide the answer by the project cost and multiply the answer by 100 to give the percentage

Question 4

Evaluation of ARR

Answer 4

Pros
Easy to understand

Cons
Does not take into account the time value of money

Question 5

Discounted cashflow (net present value)

Answer 5

This DFC measures the return achieved after the net cash flows have been adjusted for the effects of changing value of money over time. The project with the highest DFC/NPV is chosen

To calculate:
1. Multiply the discount rate for each year to the cash flow for the same year.

2. Add up the discounted cash flow for each of the projects
3. Deduct the project cost from the total discounted cash flow for each of the projects. This will give the discounted cash flow

Question 6

Evaluation of DFC/NPV

Answer 6

Pros
Takes into account the time value of money

Cons
The calculation is more complex than others