Investment appraisal: Understanding principles

Question 1

Traditional investment appraisal techniques

Answer 1

1. Payback period (PP)
2. Accounting Rate of Return (ARR)
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)

Question 2

Define appraisal

Answer 2

The act of assessing something (eg, value of asset)

Question 3

PAYBACK PERIOD:
- Definition

Answer 3

DEFINITION - the length of time it takes for an initial investment to be repaid out of the net cash inflow from a project.

Question 4

PAYBACK PERIOD:
- Limitations

Answer 4

LIMITATIONS:
- Ignores cash flow once the payback date has been reached.

• Simple payback ignores the effect of time value of money.
• Most relevant when the company has liquidity/financing constraints.

Question 5

ACCOUNTING RATE OF RETURN:
- About

Answer 5

• Measures profitability of an investment based on accounting profit, not cash flow.
• Looks at average annual profit.
• Means we adjust cash inflows to reflect how businesses report profit.
• Businesses compare ARR to target return to decide is an investment is worthwhile.
• Higher ARR = more profitable investment.

Question 6

ACCOUNTING RATE OF RETURN
Formula

Answer 6

ARR = ((Average annual profit)/Average investment) x 100%

Question 7

Average annual profit - formula

Answer 7

Average annual profit =
(total profit after depreciation) / life of investment

Question 8

Average investment - formula

Answer 8

Average investment =
(initial cost + residual value) / 2

Question 9

NET PRESENT VALUE and INTERNAL RATE OF RETURN - About

Answer 9

Discounted cash flow techniques.
- Adjust for the time value of money by discounting future cash flows back to their present value.

Question 10

Future value =

Answer 10

Future value =
Present value x (1 + rate of return)^periods

Question 11

INTERNAL RATE OF RETURN
- About

Answer 11

Discounted rate that makes NPV = 0
- Tells us the exact return an investment generates.
- Gives a % “return” figure
- Allows for timing of cash flows
- Less flexible than NPV
- Doesn’t tell us the scale of the investment.