Investment appraisal Flashcards
What is investment appraisal
This refers to partly finished materials/products. These partly completed products need to be valued and the quantity accounted for. There may be opening stock of work in progress and closing stock of work in progress. The closing stock of work in progress will affect your cost per unit/kg/litre calculation and should be part of your formula
what are mutually exclusive projects
The decision to adopt one of two or more competing options cancels out the other projects, for example a construction of a power station requires a decision on whether to build one powered by nuclear fuel or fossil fuel.
what are independent projects
From a given range of alternatives the decision-maker may choose any single project of a combination of all of the projects. All projects are independent of each other
what are dependant projects
with dependent projects, the choice of one project may mean changes or alterations to other aspects of the business, for example the purchase of new factory machinery may require a major alteration to the layout of a factory.
Two methods of investment appraisal
There are five methods of investment appraisal that a business may use. Only two of these methods are required at Higher
1 The Accounting Rate of Return Method
2 The Payback Method.
The Accounting Rate of Return Method
When using this method of investment appraisal, which is quite easy to calculate and understand, the estimated profit received over the life of the project is compared with its initial capital investment. The profit can be compared with either the original capital expenditure incurred or the original capital expenditure averaged over the life of the project.
Advantages of ARR
It is easy to understand AND simple to calculate.
It is compatible with a similar accounting ratio.
It draws attention to the overall profit.
Disadvantages
Profit for the year can be subject to different definitions.
The timings of the cash inflows are ignored, which ignores the time value of money.
No guidance is given as to what is a good acceptable rate of return.
The benefit of high profits in the earlier years is not accounted for.
Where time scales are different, this method is unreliable.
It is unsuitable for comparing projects of differing investment amounts.
It is not always clear whether the original cost of the investment should be used or it is more appropriate to substitute an average for the amount of capital to be invested.
the payback method
The payback method includes the time taken to recover the initial investment or expenditure. It compares how quickly projects pay for themselves when the shortest timescale would be preferable. The time taken for a project to pay for itself is known as the payback period.
The payback method is a popular method of investment appraisal because of its simplicity. Cash inflows are accumulated until they are equal to the capital outlay. The length of time that the capital is at risk is known. However, as with the ARR, the actual timing of the cash flows is ignored and there is a built-in discrimination in favour of short-term projects. Cash received after the payback period is ignored.
Advantages of the payback method
Easy to understand and simple to calculate.
Allows comparison of mutually exclusive projects.
Favours quick return projects which may produce faster growth for the business.
Quick return projects aid the business liquidity position.
Disadvantages of the payback method
Does not measure profitability, only cash flow.
Ignores cash inflow after the payback period.
Time value of money ignored.
Difficult to calculate net cash flows when they arise.
