Unit 10 Flashcards
What is Investment Appraisal?
This helps a business decide what projects to invest in , in order to get the best, fastest, least risky return for their money.
They also assess how much profit a project is going to make, and how the fast the money will come in. The faster the money comes in the less risk in the long run.
What is the average rate of return?
This compares the net return with the level of investment. The net return is the income of the project minus costs, including the investment.
The higher the ARR, the more favourable the project will appear.
(ARR also known as Accounting rate of Return)
How do you work out ARR?
(average net return/Investment) x 100
What is Payback Period?
The payback period is the time it takes for a project to make enough money to payback the initial investment
How do you work out Payback period?
Amount Invested/Annual net return
What are the advantages of ARR?
It is easy to calculate and understand
It takes account of all the projects cash flows
What are the disadvantages of ARR?
It ignores the timing of the cash flows
It ignores the time value of money
What are the advantages of Payback Period?
It’s easy to calculate and understand
It’s very good for high tech projects or any project that might not provide long term revenues
What are the disadvantages of Payback Period?
It ignores cash flow after payback.
It ignores the time value for money
What is the time value of money?
Risk and opportunity cost both increase the longer you have to wait for money, which means that it is worth less.
What is discounting?
Discounting is the process of adjusting the value of money received in the future to its present value. It is done so that investors can compare like with like when they look at the cash inflows they’ll receive from projects. The value of 4m is a lot different in 5 years time then what it is now.
What is the discounting factor?
The discount factor is like the opposite of a bank interest rate. Discount factors are always less than 1, because the value for money in the future is always less than its value now.
They depend on what the interest rate is predicted to be. High interest rates mean that the future payments have to be discounted a lot to give the correct present values. This is so that the present value represents the opportunity cost of not investing the money in the bank where it could earn a nigh high interest rate.
What is discounted cash flow DCF?
Discounted cash flow is an investment appraisal tool that uses the net present value to calculate the return of the project.
What is net present value?
Net present value is the value of the project assuming all future returns are discounted to what they would be worth if you had them now, which is always less than their face value (because of inflation and lost interest).
If you end up with a negative NPV, that means that the business could get a better return by putting their money into a savings account rather than going ahead with the project. Businesses will usually only go ahead with projects with a positive NPV - projects that are make them money.
How can business objectives and strategy can influence investment decisions?
Many firms will only make an investment if the project will help them achieve their objectives.
Human resources investment takes away from short term profit, so a firm with the objective of maximizing profit for shareholder dividends would be unlikely to invest too highly in staff development. On the other hand, a business which aims to produce high quality, high tech products would invest in skilled staff.
