Investment Appraisal Flashcards
What is an investment ?
the purchase of an asset with the potential to yield future returns.
What is Investment Appraisal?
The quantitative techniques used to calculate the financial costs and benefits of an investment decision.
Methods of Investment Appraisal
Payback Period
Accounting Rate of Returns (ARR)
Net Present Value
Payback Appraisal
The period of time for an investment project to earn enough profits to repay the cost of the initial investment.
PA Formula
Payback Period = Initial Investment / Contribution per month
or
= Initial Investment / (Contribution per year/12)
When the profits are not the same each year for Payback Period
Use the cumulative cash flow method.
eg. Initial investment = $950
Cash Flow Cash Flow
Normal: Year 1 $500 Year 2 $500
Cumulative : Year 1 $500 Year 2 $1000
Payback after year 1 :$950 - $500 = $450
Cash flow per month for year 2 : $500/ 12= $41.67
Number of months : $450/ $41.67 = 10.8 months
Therefore PA= 1 year and 10.8 months
Uses of Payback Period Calculations
Managers can use the payback period for one investment with another and compare by ranking in order
Uses of Payback Period Calculations
Businesses may have a “cut-off” period for payback and decided whether the investment is favorable
Advantage of PBP : Calculation
It is quick and easy to calculate
Disadvantage PBP: Opportunity
If business’ focus is on the payback period, they may not invest in a good opportunity.
Advantage PBP : Understanding
Results easily understood by managers
Advantage PBP : Speed of Return
The emphasis on speed of return of cash flows gives the benefit of concentrating on the more accurate short-term forecasts of the project’s profitability.
Advantage PBP: Late returns
The results eliminates projects that would deliver returns too late in the future
Advantage PBP: Liquidity
It is particularly useful for businesses where liquidity is of greater significance than overall profitability.
Disadvantage PBP: Profitability
It does not measure the overall profitability of a project – indeed, it ignores all of the cash flows after the payback period. It may be possible for an investment to give a really rapid return of capital but then to offer no other cash inflows.
Problems with Payback Period : Interest
A business may have borrowed the finance for the investment and along payback period will increase interest payments.
If capital is not a loan, the opportunity cost, money that could be used in other investments are seized.
Concept : Speed
The speedier the payback, the more quickly the capital is made available for other projects.
Concept: Time
Cash Flows in the future have less real value than cash flows today due to inflation. The more quickly repaid the more the real value will be.
Concept: Time with managers
Some managers are ‘risk-averse’– they want to reduce risk to a minimum so a quick payback reduces uncertainties for these managers. Cash flows in the future have less certainty that current ones. (real value lessens)
Quantitative Investment Appraisal Requirements: Capital
Initial capital cost of the investment including all installation costs
Quantitative Investment Appraisal Requirements: Expectancy
The estimated life expectancy of the investment- how long can returns be received from investment
Quantitative Investment Appraisal Requirements: Residual Value
After the assets are no longer needed, can they be sold for more money?
Quantitative Investment Appraisal Requirements: Forecasted Net Returns
Are the returns of the investment greater than the annual running cost? (investment- cost of running )
Average Rate of Return(ARR) definition
Measures the annual profitability of of an investment as a percentage of the initial investment.
ARR formula
(Total profit product’s life span ÷ number of years of the project / Initial amount invested ) x 100
ARR expression
expressed as a percentage
ARR use
allows managers to compare the rates of return with other projects
Criterion Rate of ARR
The minimum rate of return that managers desire on an investment
Rate of ARR vs. interest rate
If interest rate is equal to or less than the ARR rate then the investment is not worth risking.
Annual forecasted net cash Flow =
forecasted cash inflow - forecasted cash outflow
Factors the affect Forecasts
External Factors that affect forecasts of investment appraisal that reduce accuracy
- Possible economic recession, returns may be less and the dollar may devalue increasing payback period
- Costs may increase for raw materials for investment
When is the investment made?
year zero (0) and is a bracketed amount as it is a cost
Long pay back period
Increase Payments due to inflation
Advantages of ARR: Cash Flow
Uses all the cash flows unlike payback method
Advantages of ARR: Profitability
Focuses on profitability which is the main pivotal point that managers used to make decisions.
Advantages of ARR: Comparison
Easy to understand results and use them to compare with other investment projects especially if their is limited investment funds available
Advantages of ARR: Criterion Rate
Results may be easily measured against the criterion rate for quick analysis
Disadvantages of ARR: Time Payback
It ignores the time that the cash flows will come and two projects may have similar ARR but the time in which the cash flow may come are different.
Disadvantages of ARR: Cash Flow Included
Since all cash flows are included then the later cash flows that as less likely would give inaccurate results.
Disadvantages of ARR: Time Value of Money
The time value of money is ignored therefore all after subtractions are not accounted for.
Reason for using Discounted Cash Flow
Money in present time will be worth less later. Hence the ARR and PBP methods are not reliable to make a favorable decision
Reason for getting cash sooner than later
- It can be spent immediately and the benefits may be reaped immediately . No waiting involved
- Cash today is certain but future money always has uncertainty
- therefore the time value of money is taken into consideration in NPV
Variables used for NPV
interest rates and time
- the longer into the future and the higher the interest rate the less the real value of money. ( if raised internally then opportunity costs play an impact)
HOW TO CALCULATE NPV
- Multiply discount factors by the net cash flows for each year however , year 0 is not discounted
- Add the discount cash flows for each year (total present value)
- Total Present Value - Initial Investment cost
- if NPV is positive then it is profitable
Advantages of NPV : Timing
Considers timing of cash flow and their size
Advantages of NPV : Rate of Discount
Rate of discount could be varied to include different economic circumstances
Advantages of NPV : Time value
Takes into consideration the time value for money and the opportunity cost
Disadvantage of NPV : Explainable
Reasonably complex to calculate and explain
Disadvantage of NPV : Rates used
The results rely on the rates used and these may be wrong leading to inaccurate results if expectations are incorrect.
Disadvantage of NPV :
NPV can be compared with other projects only if the initial investment costs are the same because NPV does not give a percentage rate of return on the investment
