Project Appraisal Methods Flashcards
(18 cards)
ARR - Definition & Formula
The average annual rate of return is based on accounting profit on initial investment OR average investment
Traditional Method of project appraisal
ARR = (Average annual profit/average investment) x 100
ARR Pros
+ Simple and widely accepted
+ Uses profit figures familiar to managers
+ Can be linked to managerial performance (e.g., ROCE)
+ Easy comparison between projects
ARR Cons
- Ignores project life and risks over time
- Does not consider time value of money
- Profit figures can be affected by accounting policies
- Inconsistent if different profit definitions are used
- Not useful for staged investments or reinvestment assumptions
Payback Period - Definition
Time taken for project cash inflows to cover the initial investment.
Payback will be the first year the company pays back the initial investment (it may exceed the amount), but the threshold must be crossed
Payback Period Pros
+ Payback period uses cash flows, not profits
+ Simple to calculate
+Adaptable to changing needs
+Encourages quick return and faster growth
+Useful when dealing with a company that is rapidly changing - ie tech firm
+Maximises liquidity
Payback Period Method Cons
- Payback period ignores cash flows after the project payback period
- No definitive investment answer as to whether to invest or not
- Ignores the timings of cash flows, and doesn’t account for the time value of money
- Only calculates payback period ignores profitability
Compounding Vs Discounting
Compounding: Calculating future value of present cash flows
Discounting: Calculating present value of future cash flows
Annuity
A series of fixed amounts paid at annual intervals for a fixed period of time.
PV of annuity = Fixed annual cash flow x PV of annuity
Fixed annual cash flow / discounting rate.
NPV
Sum of discounted cash inflows and outflows at a given discount rate.
NPV Pros
+ Theoretically superior to all other methods
+ Considers time value of money through discount rate
+ Absolute measure of return
+ Based on cash flows not profits
+ Takes into account all cash flows throughout the life of a project
+ Maximises shareholder wealth by only undertaking projects with positive NPV
NPV - Cons
- Difficult to explain to managers as it uses cash flows
- Discount rate calculation challenges
- Complex compared to non-discounting methods like payback period and ARR
IRR
IRR is the discounting rate at which the NPV of a project is equal to zero
IRR Pros
+ Uses real cash flows and time value of money
+ Provides a percentage return easy to compare with cost of capital
+ Accounts for risk by comparing IRR with cost of capital
IRR Cons
- Ignores project size and duration
- Complex, often requires software for accuracy
- Can give multiple IRRs for unconventional cash flows
- Assumes reinvestment at IRR rate, which may be unrealistic
- Not ideal for mutually exclusive projects or capital rationing
Discounting Payback Period (DPP)
Time to recover initial investment using discounted cash flows.
DPP - Pros
+ Considers time value of money
+ Uses cash flows
+ Accounts for risk via discount rate
DPP - Cons
- No clear decision criterion for value creation
- Requires estimate of cost of capital
- Ignores cash flows after discounted payback
- Complex with multiple negative cash flows
Profitability Index Method
Comparing the present value of future cash flows to the initial investment. It helps determine how much value an investment will generate for every unit of investment.
PI = NPV ÷ initial investment
