Investment Appraisal Flashcards
What is investment appraisal?
Investment appraisal is a process a business will go through before deciding on major capital investments
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.
Independent projects
From a given range of alternatives the decision-maker may choose any single project, a combination of projects or all of the projects. All projects are independent of each other.
Dependent 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.
What are the 2 methods of investment appraisal?
The accounting rate of return method
Payback method
What is the accounting rate of return method?
When using this method of investment appraisal, 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 the accounting rate of return method
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 of the accounting rate of return method
Profit for the year can be subject to different definitions.
The timings of 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 earlier years is not accounted for.
Where the time scales are different, this method is unreliable.
What is 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.
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.
