Investment appraisal Flashcards
What is the purpose of investment appraisal?
To allow businesses to compare projects so that a business can expand effectively to best meet its aims and objectives
What does payback do?
Calculates the length of time taken to recover the initial investment
What is the formula for the final month of payback?
amount left to be repaid / (Income for the year / 12)
What is the formula for the final month of payback?
amount left to be repaid / (Income for the year / 12)
What are the benefits of payback compare to ARR and NPV?
Takes into account the timings of cash flows. Especially important for a business with weak cash flow and those seeking quick returns
May be more accurate than ARR/NPV, because it ignores longer-term forecasts
What are the constraints of payback compare to ARR and NPV?
Provides no insight into profitability and therefore it is not useful on its own
May encourage a short-term attitude.
What does ARR do?
Estimates the profitability per year of the project as a % of the initial investment.
How do you calculate ARR (%)?
- Find total profit (Profit = add up all net cash flow - initial investment)
- Profit per year (profit / amount of years )
- ARR (Profit per year/ initial investment X 100)
What are the benefits of ARR?
Easy to compare percentage returns on different investments, to help make a decision
Focuses on profitability and uses all the cash flows over the project’s life
What are the limitations of ARR?
the results may not prove as accurate as payback as it includes later years
Ignores the timings of cash flows and therefore ignores the opportunity cost of money in the future versus money today
What does NPV do?
This estimates the current value of the future estimated cash flows resulting from an investment. It uses discount factors to show the time value of money.
How do you calculate NPV?
Each years net cash flow X discount factor
Add them all up - Initial investment
What are the advantages of NPV?
Takes into account the amount and timings of cash flows
Takes the opportunity cost of money into account
Can consider different scenarios
What are the limitations of NPV?
May be less accurate
Only comparable between projects if initial investment is the same
What are the limitations of Investment appraisal?
- They are just estimates and may not be accurate as anything can happen in the future
- Business will need to take into account qualitative factors as well such as: the competitive environment, the economy and the social responsibilities of the business.
