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- helpful for industries where assets become outdated quickly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
Nature of cash
depreciative asset
