week 9 Flashcards
two forms of investment appraisal
payback method
accounting rate of return
accounting rate of return
average annual accounting profit/ average investment x100
average investment
initial investment + scrap value / 2
decision criteria
-accept or reject (if ARR exceeds benchmark)
- mutually exclusive ( choose item with highest ARR)
disadvantages ARR
-doesn’t consider timings of cash flow
-measurement ambiguous (profits manipulated through choice of scrap value)
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advantages of ARR
-simple to understand
- incorporate all cash flows throughout projects whole life
-shareholders use companies overall ARR
payback method
measures length time it takes for subsequent net cash flows arising from an investment to repay the initial capital invested
decision criterion
accept or reject (repay within specific period)
mutually exclusive (pay back in shortest time)
advantage of payback period
- easy to calculate, easy to understand
- use cash flows rather than accounting profit (open to manipulation)
-less bias
-ignores post payback cash flows (saves time)
disadvantages of payback period
- liquidity not wealth maximisation
-ignores timing cash flows
-ambiquity in measurement
discounted cash flow methods
-net present values
-internal rate of return
time value of money
-risk - anticipated receipt next year is not
-inflation
-interest foregone
advantages
- uses cashflows rather than accounting profit
- takes into account time value of money
- directly related to objective of maximising shareholder wealth
-takes account of all relevant cashflows over life
disadvantages
- difficult to estimate values of cash inflows and outflows over the life of project
- cost of capital (discount factor) is difficult to estimate, and likely to change over life of project
Annuity
when you receive same amount of money for more than one year in a row
internal rate of return (IRR)
discount rate that gives a project a zero NPV
decision rule
- only accepts projects with IRR above predetermined cut off rate
- where projects are completing, choose project with highest IRR
advantages IRR
takes account of all cash flows and time value of money
disadvantages IRR
-not user friendly in terms or working it out
- can give conflicting investment decision advice to the NPV method in situations of mutually exclusive projects which involve different levels of investment
