Unit 3.8 Investment Appraisal Flashcards
Investment Appraisal
The quantitive technique of evaluating the viability and attractiveness of an investment
Payback period formula
initial investment cost / annual cashflow from investment (years)
Average rate of return (ARR) define
Measures the annual net return on an investment as a percentage of its capital cost
Average rate of return (ARR) formula
total returns - capital cost / average annual profit / capital cost * 100
Discounted cash flow
use a discount factor that converts future cash flows to their present value
Net present value
advantages vs disadvantages
advantages
- all cash flow included
- discount rate can be included to suit any expectancies
- opportunity cost and time value of money are put into consideration in the calculation
disadvantages
- more complex
- can only be used to compare investment project with same initial cost layout
- discount rate greatly influences final NPV, makes inaccurate predictions
Criterion rate
internal benchmark for acceptance of investment projects (ARR)
Evaluate PBP as a business tool
advantages
- simple, easy and quick
- helpful for industries where assets become outdated quickly
disadvantages
- ignores overall profitability
- cash flows are just a prediction
= too simple to use on its own
Evaluate ARR as a business tool
advantages
- simple, quick and easy
- goes further than PBP taking into account profitability
disadvantages
- ignores timings of returns (inaccurate)
= too simple to use on its own
Evaluate NPV as a business tool
advantages
- includes both time and cash value
- flexible (discount factor may be altered based on the state of the economy)
- widely used technique that takes into account several factors at the same time (profitability, economy and time)
disadvantages
- relatively more complex
- somewhat inaccurate, the interest rate is unlikeñy to stay the same
= too simple to use on its own
Present value formula
today’s value of future cash (cash * discount factor)
Net Present Value
Represents the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
Net Present Value formula
∑present values of return (net cash flow * discount factor) - original cost
Pay back period
time required for an investment to recover its initial cost in terms of profit
Discount factor
multiplied by predicted cash flow gives present value
