Investment appraisal Flashcards
What is investment appraisal ?
Process used to determine whether funds given to a business for investment are likely to generate a profit
What is the purpose of an investment appraisal ?
To evaluate attractiveness of a possible investment in quantifiable terms - lower risks in taking appropriate course of action
What 3 things does understanding risks help a business to do ?
- Assess general feasibility of undertaking a project
- Consider other approaches
- Reveal level of investment required of a project to be successful
What is payback ?
Amount of time taken for a business to recover the initial amount invested
What is the equation for payback when annual net cash flows are constant over time ?
Sum invested / net cash per time period
What is the equation for payback when annual net cash flows fluctuate over time ?
Investment outstanding / monthly cash in year of payback
What 2 things does payback show ?
- When an investment will be fully paid back
- Point at which a business will start to make a profit
What is average rate of return ?
Average annual return on an investment for a profit as a %
What is the equation for average rate of return ?
Average annual profit / initial outlay x100
What 2 reasons does a business use average rate of return ?
- Compare possible projects
- Takes into account risk and period of time return is forecast to take place
What is discounted cash flow ?
Calculating present value of an investments future cash flows in order to arrive at current value of investment
What is current value of investment also known as ?
Net present value
What 2 things does discounted cash flow take into account ?
- Profits from an investment
- Time taken to achieve return
What is net present value ?
Present value of all money coming in from project in the future against money invested today
What are the 3 steps to calculating net present value ?
- Multiply net cash flow of year by discount factor of year
- Equates to present value
- Add present values for each year together
Why does net present value show a more realistic view of investment ?
Draws attention to the value of return in present
What are 3 advantages of payback ?
- Simple to use & easy to interpret
- Focuses on cash = important to everyday success
- Straightforward to compare competing investment when resources are limited
What are 3 disadvantages of payback ?
- May encourage short term thinking about investment
- Ignores qualitative aspects
- Ignores cash flow after payback, can’t be used on its own to make decision on investment
What are 3 advantages of average rate of return ?
- Uses all cash flows over project life
- Focuses on profitability
- Easy to compare returns on range of different investments
What are 3 disadvantages of average rate of return ?
- Projected cash flows may be inaccurate = affect whole ARR
- Ignores timing of cash flows = may only be positive towards end of investment
- Ignores opportunity cost = not take into account time needed to benefit from investment
What are 3 advantages of net present value ?
- Takes into account opportunity cost of money
- Takes into account timings & amounts of cash flow used
- Can be used to consider different investment scenarios in terms of interest rates
What are 3 disadvantages of net present value ?
- Calculation is complex = difficult to communicate to investors
- Results can be misunderstood
- Projects can only be compared if initial investment = same
What is a disadvantage with long term forecasts ?
Greater risk of inaccurate data = more unreliable the appraisal process is
What 5 other factors need to be considered in a potential project ?
- Corporate objectives
- Business’s financial position
- Whether social & ethical responsibilities are reflected
- Risks
- Uncertainty
