Investment Appraisal (3.3.2) Flashcards
What is meant by the term investment appraisal?
Using cash flow forecasts to assess the financial attractiveness of an investment decision. Comparing expected future cash flows of an investment with the initial outlay for that investment. Basically which one gives them more profit
What two things does the business consider when deciding which investment to go with?
- How soon the investment will recoup the initial outlay
- How profitable the investment will be
What information needs to be collected for the investment appraisal?
-Sales Forecasts
-Fixed and variable costs data
-Pricing information
-Borrowing costs
What does the collection of data for investment appraisal to be worked out need?
-Time
-Someone with significant experience to interpret the data
What are the three methods of Investment Apprasial?
-Payback period
-Average Rate of Return
-Net Present Value
What is the Payback Period?
Focuses on how long it will take for an investment to pay for itself.
What’s the formula for Payback Period?
Sum Investment/ Net Cash Per Time Period= Years/ Months
If Gomez Carpets is considering an investment in a new storage facility at a cost of £200,000. It expects additional net cash flow of £30,000 per year as a result of the investment. Calculate the Payback period for the investment (3)
Step 1- Divide the initial outlay by the additional expected net cash flow: 200,000/ 30,000=6.67 years
Step 2- Convert outcome to years and months: 6 years + 8.04 months
So Payback Period = 6 years and 8 months
What does the payback period being short mean?
The quicker the pp, the less time your investment is at risk
What are the Advantages of Payback?
-Easy to calculate and interpret
-May be more accurate as it ignores longer-term forecasts
-Takes into account the timings of cash flow
-Important for businesses with poor cash flow to reduce the risk of longer investments
What are the Disadvantages of Payback?
-Provides no information on profitability
-Ignores what happens after the payback
-May become too short-sighted
-More beneficial used alongside ARR or NPV
What is Average Rate of Return (ARR)?
-Compares the average profit per year generated by an investment with the value of the initial outlay
-This can then be compared against other investments
What is the equation for ARR?
Average annual return/ initial outlay x100
Outcome is expressed as a percentage
How do you work out average annual return?
(Cash inflows - cash outflows)/ amount of years
What are the three steps to calculating ARR?
- Total Net Cash Flow- Initial Investment=Investment Profit
- Investment Profit/ Years of Investment=Average Annual Profit
3.(Average Annual Profit/ Investment Outlay) x100=ARR
Creative Frames, a small artwork framing business, is considering an investment of £40,000 in new machinery. Megan, the business owner, believes that total cash inflows over a 6-year period will be £140,000 and total cash outflows will be £92,000. Calculate ARR of proposed investment (4 Marks)
Step 1-Calculate the total profit over the lifetime of the investment: Total cash inflows- Total cash outflows= Total profit: 140,000-92,000= 48,000
Step 2- Divide the total profit by number of years of investment project to find average annual profit: £48,000/ 6 years=8,000
Step 3- Divide the AAP by initial outlay: £8,000/£40,000= 0.2
Step 4- Multiply the outcome by 100 to find the percentage:
0.2x100=20%
Is it better if the ARR is high or low?
The higher the ARR the better. Unless the investment has another object. The higher ARR tends to be the one the firm invests in.
What are the Advantages of ARR?
-Use all cash flows over the years of investment
-Focuses on the profitability
-Easy to compare % returns against other investment opportunities to make a decision
What are the Disadvantages of ARR?
-Later years hard to predict making results less accurate than payback
-Ignores the timing of cash flows
-Ignores the time value and opportunity cost of the money invested
Are ARR and Payback Period better used together or separately?
These two techniques work best when used together
What is Net Present Value (NPV) or Discounted Cash Flow?
Financial metric used to evaluate the value of an investment or a project. Takes into account the effects of interest rates and time
Is it better for NPV to be higher or lower?
Higher the NPV the more profitable the investment is. Positive NPV shows investment will give a greater return than other opportunities.
How do you work out NPV?
Step 1 - Calculate the discounted cash flow for each year by multiplying the net cash flow by the discount factor
Step 2 - Add together the discounted cash flow values for each year, including Year 0
What are discount tables?
Discount tables are tools used in finance and accounting to determine the present value of a future amount of money, based on a given discount rate and period of time. They simplify the process of discounting cash flows by providing pre-calculated values for commonly used discount rates and time periods.
