Investment Appraisal - Payback Period

Question 1

What is investment appraisal

Answer 1

The process of analysing whether investment projects are worthwhile

Question 2

What are the main methods of investment appraisal

Answer 2

-Payback period -Average rate of return -Discounted cash flow (NPV)

Question 3

What is meant by payback period

Answer 3

The time it takes for a project to repay its initial investment

Question 4

How do you calculate payback

Answer 4

• Identify net cash flows for each period (e.g year) - Keep a running total of the cash flows: - initial investment = an outflow - When does the running total move from negative (outflow) to positive (inflow) - When the total net cashflow becomes positive that is the end of the payback period

Question 5

Benefits of using payback period

Answer 5

• Simple and easy to calculate + easy to understand results - Focuses on cash flows - Emphasises speed of return; good for markets which are changing rapidly - Straight coward to compare competing projects

Question 6

Drawbacks of using payback period

Answer 6

-Ignores cashflows after payback has been reached - Takes no account of the ‘time value of money - May encourage short term thinking - Ignores qualitative aspects of a decision - Does not actually create a decision for the investment

Question 7

Calculate the payback for this question

Answer 7

To calculate precise payback:

3 years + (required amount to reach payback / total cash flow in during period)

3 + (75,000/150,000) = 3.5 years