Investment Appraisals Flashcards
What is the Payback method?
Attempts to estimate how long before the project starts to pay for itself.
What is the discounted Pay Back Method?
Because the payback method ignores the timing of the net cash receipts, this method will discount the net cash receipts.
What is the internal rate of return?
This method is similar to the NPV method with the following exception. Instead of discounting the expected net cash flows by a predetermined rate it estimates the required rate of return to ensure that the total NPV equals the total initial cost.
What is the accounting rate of return?
This approach (ARR)attempts to compare the profit of a project with capital invested in it.
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What is the Net Present Value?
This method unlike the payback and ARR methods does take into account the time value of money.
What are the pros of the NPV?
Time Value of Money: NPV considers the time value of money by discounting future cash flows back to their present value. This provides a more accurate reflection of the value of cash flows over time.
Objective Decision Making: NPV provides a clear and objective basis for decision-making. If the NPV is positive, it generally indicates a financially sound investment.
Consideration of Risk: By incorporating a discount rate, NPV implicitly accounts for the risk associated with future cash flows, providing a risk-adjusted measure of project profitability.
What are the Cons of NPV?
Cons of NPV Appraisal:
Complexity: NPV calculations can be complex, especially for projects with varying cash flows over time. It requires a clear understanding of discount rates and cash flow patterns.
Assumption of Reinvestment Rate: NPV assumes that cash flows can be reinvested at the discount rate, which may not always reflect the actual rate at which funds can be reinvested.
Sensitivity to Discount Rate: The NPV is sensitive to changes in the discount rate. Small variations in the discount rate can lead to significant changes in NPV.
