Unit 9- Investment Appraisal Flashcards
Investment appraisal
What is investment appraisal
This is a technique used to evaluate planned investment by a business and measure its potential value to that business.
Investment appraisal
Investment appraisal Methods
- Payback period
- Average Rate of return
- Discounted cash flow
Payback period
Benefits and Drawbacks of Payback Method
Advantages
* Simple to use
* Easy to calculate
* Effective to use when technology is changing at a fast rate
* Helps with managing cash flow
Disadvantages
* Ignores flows of cash over the lifetime of the project
* Ignores total profitability the foucs is just the speed at which the inital outlay is paid
Payback Period
Payback Period Method
- This is done by adding the cumulative cashflow per year.
- If the payback falls between years then the following formula is used.
Income needed in period / Contribution needed per month
Average Rate of Return ( ARR)
Average Rate of Return
This measures the average net return every year with the cost of invetsment. This is expressed as an percentage for allowing a straightforward comparison. The option that has the highest ARR is chosen
Average Rate of Return ( ARR)
Average Rate of Return Method
- Calculate the total cumulative cash flows for both options
- Calculate the Average profit per annum by dividing the figures in step 1 by the number of years the project is for
- Divide the average net cash flow per annum by the initial cost of the project and multiple by 100
Average Rate of Return ( ARR)
Benefits and Drawbacks of ARR
Benefits
* Shows the profitability
* Includes all the projects cash flows
* Easy to compare different projects
* Allows comparison with costs of borrowing for investment
Drawbacks
* Ignores the timing of the cash flow
* Does not allow for effects on inflation on values of future cash flows
Discounted Cash Flow (DCF)
Discounted Cash Flow
This takes into account the time value of money. It calculates the net present value (NPV) of alternative options.
NPV takes into account inflation and the potential for earning interest on investment capital or cost of finance on raising investment capital
Discounted Cash Flow (DCF)
Discounted Cash Flow Method
- Use the Net cash flows and then mutiply the cash flow for each year by the discount factor for that year
- Then calculate the NPV by subtracting the inital investment
Discounted Cash Flow (DCF)
Benefits and Drawbacks of Discounted Cash Flow
Benefits
* Allows for future earnings to be adjusted to present values
* Easy to compare projects
* Allows for impact of inflation
* Discounts can be changed to take into account the economic climate
* Allows for the effect of risk on estimated futre cash flows
Drawbacks
* It is difficult to calculate
* Discount factors could be inccorect which makes NPV inaccurate
* Difficult to set discount factors far into the future the longer it is the less reliable the discount factor
Qualitiative Factors which affect investment appraisal
- Impact on staff
- Impact on existing products
- Does the investment match the strategy and objectives of the business
- The state of the economy
- Action of competitors
- Does the investement have any ethical considerations
- Is there sufficent funding available to invest into the project
- Availablity of new technology
- Confidence of managers
