Investment Appraisal

Question 1

what is investment appraisal?

Answer 1

• refers to the quantitative techniques used to calculate the financial costs and benefits of an investment decision.
• aims to establish if it is worth pursuing a particular business and if it will be profitable
• helps the business to compare different investment projects

Question 2

different methods of investment appraisal

Answer 2

Payback Period (PBP)
Average Rate of Return (ARR)

Question 3

Payback Period (PBP)

Answer 3

estimates the period of time for an investment project to earn enough profits to repay the cost of the initial investment, looking at how long the business will take to recover its initial investment from its net cash flow.

Question 4

Payback Period formula

Answer 4

𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅(𝑷𝑩𝑷)= (𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 𝑪𝒐𝒔𝒕)//(𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘 𝒇𝒓𝒐𝒎 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕)

Question 5

advantages payback period

Answer 5

Simple calculation that tells the firm whether an investment will meet its cost
Easy method to compare with other investments
Time focused which is especially important for companies that have liquidity problems (remember that companies typically fail because of cash flow issues, not profitability)
Focuses on short term which is when forecasts are more likely to be correct

Question 6

disadvantages payback period

Answer 6

Ignores potential gains that happen after payback period has occurred. This could influence major decisions
Ignores the profitability of the project by focusing only on how quickly will be paid back.
Focus is on time instead of return. This puts too much focus on short term goals.
Does not consider external factor that might affect demand, which could affect the payback period.

Question 7

Average Rate of Return (ARR)

Answer 7

measures the annual net return on an investment as a percentage of its capital cost. It assesses the annual profitability generated by the project over a period of time.

Question 8

Average Rate of Return (ARR) formula

Answer 8

((𝒕𝒐𝒕𝒂𝒍 𝒓𝒆𝒕𝒖𝒓𝒏𝒔−𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒄𝒐𝒔𝒕)//(𝒚𝒆𝒂𝒓𝒔 𝒐𝒇 𝒖𝒔𝒂𝒈𝒆))//(𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒄𝒐𝒔𝒕) 𝐱𝟏𝟎𝟎

Question 9

Net return per annum

Answer 9

( 𝒕𝒐𝒕𝒂𝒍 𝒓𝒆𝒕𝒖𝒓𝒏𝒔−𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒄𝒐𝒔𝒕)/(𝒚𝒆𝒂𝒓𝒔 𝒐𝒇 𝒖𝒔𝒂𝒈𝒆)

Question 10

advantages ARR

Answer 10

Simple calculation that will show the profitability of an investment in a given period of time. That is, whether an investment will return more or less than a specific benchmark.
It makes use of all the cash flows in a business (unlike the PBP)
Easy metric to compare with other investments

Question 11

disadvantages ARR

Answer 11

Does not take time into consideration. There is more scope for errors (even last years investment) leading to an incorrect ARR.
Does not include time value of money. Would you rather have a £1,000 today or £1,000 5 years from now? ARR does not differentiate this.
It does not consider the timing of cash inflows. Two projects might have the same ARR but one could pay back quicker than the other.