2.5 Flashcards
What is investment appraisal?
Process of evaluation how attractive a business project or idea is
What is payback?
The time it takes to recover the initial investment in a project
What are the advantages of payback?
Widely used as it is easy to understand
Focuses on liquidity which is important if a business has limited funds
Risk of a project with a short payback period is lower than that of a longer payback so is preferred
What are the disadvantages of payback?
Cash flow is not discounted so the time value of money is not recognsied
Payback emphassies liquidity and ignores profitability
Calculation ends as soon as payback is reached
Projects with longer payback might be more profitable than those with shorter
Short term approach – cash flow after not considered
What is average rate of return (ARR)?
The percentage rate of return a business can expect to obtain on average each year
What is the ratio for ARR?
(average net profit/initial investment) X 100
What are the advantages of ARR?
Takes profitability into account, which is an important performance indicator
Takes into account cash flow throughout the lifetime of the project
What are the disadvantages of ARR?
Ignored the time value of money
The calculation of average profit does not take into account the timing of cash flow, which can be a priority for businesses with limited funds
What is net present value (NPV)?
A technique that takes into account that the value of money usually falls over time
What are the advantages of NPV?
Takes into account time value of money
Considers all the cash flow in the whole lifetime of a project
Can be easily compared with a target
What are the disadvantages of NPV?
The choice of discount factor might not reflect accurately the rate at which it has depreciated over the lifetime of the project
Cash flow is estimates, so accurate requires skills and experience
