Investment Appraisal Flashcards
What is investment appraisal?
The process of analysing whether investment projects are worthwhile.
What are the 3 methods of Investment Appraisal?
Payback period (time days years)
Average rate of return (%return)
Discounted cash flow (NPV)(monetary value)
What does the term payback period mean?
The time it takes for a project to repay its initial investments
What does the term average rate of return refer to?
Looks at yhr total accounting return for a project to see if it meets the target return.
What is discounted cash flow?
Net present value calculates the monetary value now of the projects future cash flow.
Benefits of payback period
-Simple and easy to calculate
-Focuses on cash flows
-Emphasises speed of return
-Straightforward to compare competing projects
Drawbacks of payback period
-Ignores cash flows after payback has been reached
-Takes no account of the time value of money
-May encourage short term thinking
-Ignores qualitative aspects of a decision
-Does not actually create a decision for the investment
What is the Annual Average Return? (ARR)
Measures the money made or lost by a mutual fund over a given period
Average annual profit
Total annual profit/years
Average rate of return
Average annual profit/investments
Benefits of using ARR
-Easy to understand and calculate
-Focuses on the overall profitability of an investment project
-Easy to compare ARR with other key target rate of return to help make a decision
-Uses all the returns generated by the projects
Drawbacks of using ARR
-Ignores the timing of returns
-Focuses on profits rather than cash flows
-Doesn’t adjust for time value of money
Present value
Cash flow x Discount factor
Benefits of using npv
-Consider all future cash flows
-Reflects the risks that future cash flows will not be as expected
-Different levels of risk can be accounted for by adjusting the discounted rate
-Creates a straightforward decision positive npv suggest profit will be made
Drawbacks of using npv
-The most complicated method compared with payback and arr
-Choosing the discount rate is hard particualrly
