Flashcards in Chapter 33 (investment appraisal) Deck (17):
investment appraisal is?
evaluating the profitability or desirability of an investemnt
what info do you need to appraise an investment?
1. the initial capital cost of the venture, including e.g equipment and machinery + installation costs.
2. estimated life expectancy - how many years till return can be expected.
3. the residual value
4. annual forecasted net cash flows
residual value is
known also as scrap value. at the end of an investments useful life span, the residual value is the additional net return earned
The five quantitive methods of appraisal are?
1. payback period
2. average rate of return (A.R.R)
3. discounted payback
4. net present value
5. internal rate of return
annual forecasted net cash flows is
the forecast cash inflows - forecast cash outflows
what external factors could affect the revenue forecast?
1. an economic recession
2. fluctuation in the price necessary goods
3. new advancements in technology
4. competitors expanding, or growing.
payback period formulae
additional net cash inflow needed
annual cash flow flow in that year
payback period is?
length of time it takes for the net cash inflows to pay back the original capital cost of the investment
2 reasons payback period is important
1. a business may have borrowed the finance, a long payback period will increase interest payments
3. the more time the finance isn't made back the more uncertain it becomes
advantages to payback period
1. it is quick and easy to calculate
2. the results are easily understood
3. useful in eliminating investment that wont pay pack within a certain time period
4. useful for companies where liquidity is os greater importance than overall profitability
5. the speedier the payback the quicker that money can be reinvested
disadvantages to payback period
1. it does not measure the overall profitability of the firm
2. the focus on the short term, business might miss an opportunity just cause it may take longer
Average Rate of Return (A.R.R)
measure the annual profitability of an investment as a percentage of the initial investment.
Average Rate of Return (A.R.R) formulae
annual profit (net cash flow)
four stages of calculating A.R.R
1. add up all positive cash flows.
2. subtract cost of investment (annual total profit)
3. divide by lifespan
4. Calculate the % return to find the A.R.R
advantages of A.R.R
1. it uses all of the cash flows - unlike the payback method
2. it focuses on profitability, which is the central objective of many businesses
3. results easy to understand and compare with other A.R.R
4. the result can be quickly assessed against predetermined criterion rate (more than 15% normally)
disadvantages of A.R.R
1. it ignores the timing of the cash flows. could result in 2 A.R.R's having same % but one actually paying back quicker
2. all cash flows are needed, later cash flows are less accurate and are incorporated in the calculation
3. the time value of money is ignored