Investment Appraisal Flashcards
What is investment appraisal?
Establishing wether an investment will be worthwhile
What are the three ways of calculating investment appraisal?
Payback, average rate of return (ARR), net present value
What is payback?
The time it takes for a project to repay its initial investment
What is average rate of return?
Looks at average rate of return for a project to see if it meets the target
How is average rate of return calculated?
Total net profit/no. of years (average annual return) / investment (initial cost)
What are the advantages of ARR?
- focus on profit rather than payback
- easy o compare diff investment projects
- can compare return on investment with return for whole business
What are the disadvantages of ARR?
- doesnt take into acc timing of cash flows
- fails to determine if more profitable at start or end of life (uses av profit)
- ignores the value of money, profit in 5 years will be worth less
What are the advantages of payback?
- simple to apply
- appropriate when technology changing rapidly
- helpful to analyse cash flow problems
- risk in investment is reduced with shorter cash flow
What are the drawbacks of payback?
- ignores all ash flowers after payback period - could lead to more profitable options being ignored if just take shortest payback period
- ignores overall profitability of investments
- ignores timing of cash flows within payback period. Assumes constant
What is net present value?
Calculates the monetary value now of a future projects cash flow
What are the advantages of NPV?
- takes into account time and interest rates
- returns from different investment potions can be easily compared
-opportunity cost can be taken into account
What are the drawbacks of NPV?
- difficult to calculate
- not accurate if initial outlay on projects is considerably different
- future rate of interest is unpredictable, making calcs less reliable
