Investment appraisal Flashcards
What 2 major considerations are there when deciding whether or not to invest in a fixed asset?
- the total profit earned over the fixed asset’s useful life
- how quickly the asset will pay off its cost
Investment appraisal involves which 3 methods?
- payback
- average rate of return
- net present value
Define payback.
The number of years it takes to recover the cost of an investment from its earnings.
If a machine is bought for £10,000 and the additional revenue generated from using the machine is £8000 per annum, what is the payback period?
Payback=number of full years + (amount of cost left/revenue generated in next year)
Payback=1+(2000/8000)=1.25 years
What is the formula for payback?
Payback=number of full years + (amount of cost left/revenue generated in next year by fixed asset)
What is 1 advantage and disadvantage of the payback method?
- quick and simple
- ignores timing of payments & receipts
Define average rate of return (ARR).
ARR calculates the percentage rate of return on each investment.
What is the formula for ARR.
ARR=average annual profit / asset’s initial cost x 100
WHERE
Average annual profit=net profit/no. of years e.g. £200,000/5 years = £40,000
If a machine will make a profit of £200,000 over 5 years and cost £100,000 what is the ARR?
£40,000 / £100,000 x 100 = 40%
Why is ARR method more popular than the payback method?
ARR pays attention to profit, not just revenue.
Why is the net present value so good?
The NPV takes into account profits and the timing of payments and receipts.
Using the NPV method, how do you know if an investment was worthwhile?
Positive figure = worthwhile
Negative figure = not worth while
What does the discounted cash flow figure do?
Convert future earnings from n investment into their present values.
How do you calculate the NPV?
- Cash flow x discounting factors over years = present value
- Add up present values and subtract from initial investment cost=NPV
What other 2 criteria are used to determine an investment decision?
- Interest rate-does saving the money in a bank give a higher return?
- Other investment opportunities-internal and external.
