investment appraisal Flashcards
investment appraisal definition ?
a technique used to evaluate planned investment by a business and measure its potential value to the business
what is investment appraisal ?
consists of a variety of quantitative methods used to evaluate a planned investment by a business and its potential value to the firm, is how a business decides if a capital investment project is worthwhile : can be used to consider the best option if several alternatives exist, involves several numerical techniques but also takes qualitative factors into account
what are some examples of large investments ?
relocation of business, capital investment and expansion into new markets or countries
what are key considerations regarding investment projects ?
most investment decisions are uncertain because they are long term decisions, where resources are committed for a period of time
investment projects have failed in both the private sector and the public sector therefore these decisions need to be assessed thoroughly
what are factors affecting private sector investment ?
motives or reasons for the investment, is the investment required to be competitive on prices or costs or quality, is the investment due to the availability of new technology, is the investment to take advantage of growth opportunities through new investment in machinery or other fixed assets, is the investment as a result of the influence of external factors
how is investment appraisal useful ?
it helps a private sector business to objectively evaluate an investment project, it will help to establish if the project can be profitable and allows a comparison of projects
what are the three investment appraisal methods ?
payback, average rate of return (arr) and net present value (npv)
what is the payback method ?
refers to the amount of time it takes for a project to recover or payback the initial outlay
a business will always chose the ___ payback
shortest
advantages of the payback method :
- better for smaller investments
- simple to calculate and understand
- can help to consider liquidity
- focus on how quickly money can be returned from an investment
- helps to produce a relatively easy calculation of risk
- helps to compare investment projects by identifying shortest payback time
disadvantages of payback method :
- errors can be made
- ignores qualitative factors
- doesnt account for inflation
what is the average rate of return (arr) method ?
this method measures the net return each year as a percentage of the initial cost of the investment
what is the average rate of return (arr) calculation ?
average rate of return (%) = net return (profit per annum) / capital outlay (cost) x 100
how must the average rate of return (arr) be expressed in ?
a percentage
what is average rate of return (arr) used for ?
to compare different investment projects
the business will normally select the project with the ___ arr ?
highest
advantages of the arr method :
- clearly shows the profitability of an investment project
- it allows a comparison of project, and also the overall rate of return for each project
- it helps to compare with other projects which could generate a return
- considers the opportunity cost of projects
- does not take into account cashflow, it focuses on profit
disadvantages of the arr method :
- ignores external factors
- ignores loss of money over time : inflation
what is the net present value (npv) method ?
this method has certain advantages in that it deals with the problems of interest rates and time
the return on an investment is always in the future, usually over a period of years
what does the net present value (npv) method recognise ?
that money earned in the future is worth less than money earned today because of the effects of inflation
the higher levels of risk involved when cash flows are projected to be generated a long time into the future
what does the npv method allow ?
allows the return to be discounted
: to reflect the ‘real’ value of the return in future years
advantages of the npv method :
- easy to budget
- easier to use and compare
- real value of money : figures will be accurate for the timescale
disadvantages of the npv method :
- complications calculations especially for smaller businesses
- not always clear which discount rate should be used
- does not always consider the context and how appropriate the discount rate is for different industries
- time consuming
- can be difficult when comparing projects with different timescales
- higher npv does not always mean a better investment due to qualitative factors
what other factors need to be considered before a decision to invest is made ?
qualitative factors
examples of qualitative factors :
- impact on human resources of the business
- impact on existing products
- corporate aims and objectives
- external costs and benefits
- economic conditions
- competitor activities
- ethical and environmental issues and considerations
- availability for finance to invest in a project
- available of technology or equipment
- corporate strategy of the business
- market conditions
what are some issues linked to investment appraisal techniques ?
- it helps with decision making against a background of uncertainty
- it helps to balance risk with potential rewards
- consider the reliability of the data
- can focus too much on financial/quantitative factors and returns
- does not always take into account all stakeholders
- can give biased information to managers
- does not always consider the size of the business
- based on forecasts which can be unreliable
- lacks focus on the qualitative factors regarding decisions which are more prominent with increased social responsibility and the stakeholder concept
