Lecture 9a Investment appraisal ** Flashcards
What is Accounting rate of return (ARR)?
is an investment appraisal technique to calculate the average profit from a project given as a percentage of the average investment in the project
How do you calculate ARR?
Average annual operating profit/ average amount invested in the project x 100%
Average annual operating profit=Profit added up/ years
What are the four investment appraisal techniques?
- Accounting rate of return
- Payback period
- Net present value
- Internal rate of return
What are the 2 limitations of ARR?
- It is calculated based on accounting profits rather than the projects cash flows which are influenced by judgements
- ARR takes no account of timing of the profit flows. As two very different projects that have significant profits in different years could give the same ARR.
What are 2 more limitations of ARR?
- ARR ignores the time value of money
- ARR could lead to the wrong project being chosen if only the ARR percentage is considered not the actual amount of the expected profits
What is Net present value?
It is the difference between the present value of future cash inflows and the present value of cash outflows. It tells you how much profit (or loss) an investment will generate in today’s money using discounted cash flow
How do you calculate NPV?
NPV=cash flow / (1 + i)^t – initial investment
i=discount rate
t=time of cash flow
How do you find the discount rate used for NPV?
1/1.x
x=% discount e.g 5%= 1.05
What are 3 strengths of NPV?
- Shows time value of money
- Most meaningful technique as considers all relevant cash flows
- Can compare projects
- Good for long term planning
What are 5 limitations of NPV?
- Need to be able to estimate cash flows
- Subjective discount rate
- Ignores non-monetary factors
- No reinvestment of cash
- Is complex
What is the payback period?
is the amount of time it takes for an investment to repay its initial cost from the cash inflows it generates or “how long until I get my money back?”
How do you calculate the payback period?
Initial investment/ Annual cash inflow
What are the 7 steps for calculating the payback period?
Step 1: identify initial investment
Step 2: list annual cash inflows
Step 3:Calculate cumulative cash flows (Add each year’s inflow to the previous total until the cumulative amount equals or exceeds the initial investment)
Step 4: Find last full year before payback
Step 5: calculate remaining amount (InitialInvestment−Cumulativecashflowatendoflastfullyear)
Step 6:Calculate the fraction of the year (amount left to recover/cash inflow in next year
Step 7: Add years together (PaybackPeriod=Lastfullyear+Fractionofyear)
What are 3 limitations of the Payback period?
- Doesn’t take into account cash flows incurred after the payback point is reached
- Ignores timing of cash flows
- Doesn’t recognise the time value of money
What is the internal rate of return (IRR)?
IRR is the discount rate for which the net present value (NPV) equals zero (when time-adjusted future cash flows equal the initial investment).
How do you work out IRR?
r1+(NPV1/NPV1-NPV2) x r2-r1
r1= lower discount rate (with positive NPV)
r2=higher discount rate (with negative NPV)
NPV1=NPV at r1
NPV2=NPV at r2
What are the strengths of IRR?
- Easy to understand NPV=0
- Time value of money
- Compare projects
- Do not need to predefine hurdle rate
Weaknesses of IRR?
- No reinvestment of cash
- Ignores project size/scale
- Ignores future costs
- Can be misleading
When do you accept IRR?
If IRR is more than the cost of capital
When do you reject IRR?
If IRR is less than the cost of capital
What is ARR?
measures the average annual accounting profit as a percentage of either:
-the initial investment, or
-the average investment (more accurate).
What is the equation for Average rate of return (ARR)?
Average annual profit of project/initial capital required for product x 100
Average annual profit= Total profit/ years
What are the 4 strengths of ARR?
- Simple and easy
- Focuses on profit
- Give us a % return
- Can compare projects
What are the 4 weaknesses of ARR?
- Ignores the time value of money
- Based on profit not cash
- No reference to risk
- No payback assessment
