Semester 2: Lecture 1: Investment Appraisal: Understanding Principles. Flashcards
(17 cards)
What are 3 things which should be considered when an investment is being considered?
- Return
- Timing
- Risks
4 traditional investment appraisal techniques:
- Payback period (PP)
- Accounting Rate of Return (ARR).
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
Investment Appraisal Overview:
Cashflow based techniques measure cashflows and not accounting profits.
Depreciation is not a cashflow it is an accounting adjustment.
For cashflow based techniques you must used cash inflows and outflows AND NOT accounting income and expenditure.
Cashflows are assumed to take place either immediately (T0) or at the end of a period (T1, T2, T3 etc.)
What does the Payback Period Show?
The length of time it takes to pay back the initial investment to be repaid out of the net cash inflow from a project.
Payback Period Summary:
- Ignores cashflows once the payback date has been reached.
- Simple payback ignores the time value of money.
- Is of most relevance where the company has liquidity or financing constraints.
Detailed evaluation of the Payback Period Technique (Textbook):
- A shorter Payback Period can be equated with a lower level of risk.
- PP can be seen as more of risk appraisal tool than a measure of return.
- Ignores cashflows outside the Payback period, so ignores the total return.
- Also, ignores the timing of the cashflows within a payback period.
- Still the most widely used investment appraisal tool (around 80% of businesses).
- Strengths lie in simplicity, not difficult to calculate or understand.
- Useful for projects which are known to have a short life.
Accounting Rate of Return (ARR), Overview:
- Measures the profitability of an investment based on accounting profit, not cashflow.
- Unlike NPV and IRR, which focus on cashflow timing, ARR looks at average annual profit.
- Cash inflows are then adjusted to reflect how businesses report profit.
Summary of ARR:
- Focuses on profitability whereas other methods focus on cash flow timing.
- Businesses compare ARR to a target return.
- Higher ARR = More profitable investment (if risk is similar)
Evaluation of ARR (Textbook):
- Main benefit, it calculates the performance of an investment in profit terms.
- Provides a measure which is directly comparable to ROCE.
Negatives:
- ARR uses accruals concept, meaning it is calculated from profits and not cashflows which can be easily manipulated, so problems will arise when comparing the figures.
- ARR is a relative measure. ARR may be higher in smaller project, but have less profit than a bigger project. Bigger ARR doesn’t mean better investment.
- No universally accepted basis for calculating the figures used for either the profit from an investment or the capital invested to earn that profit.
- Technique ignores the timing of the profits.
- Technique is unsuitable of comparing investments of different lengths.
What are the 2 DCF techniques:
NPV and IRR
Because they both adjust for the time value of money by discounting future cashflows back to their present value.
What is the concept of the time value of money?
- Concept that money is worth more if it is received nwo instead of being received in the future.
This is because of …
- Opportunity costs.
- Effect of inflation.
- Risk/uncertainty of cashflow
What are discount rates:
The percentage we use to bring future money back to today’s value.
The compounding effect again applies.
Net Present Value (NPV):
Net cashflows for each year X Discount factors - Initial investment.
Discount rate applied represents the minimum acceptable return for the investor.
Simple rule NPV > 0 accept project
Evaluation of NPV:
- Takes account of entire cash flow of the project.
- Takes account of the timing of earnings from an investment.
- Further into future of cashflows the more they are discounted.
Increased risk and uncertainty of cashflows which are further into the future.
Internal Rate of Return (IRR): Overview
Is the discount rate that makes NPV = 0.
Tells us the exact return an investment generates.
NPV is a positive value at a certain % then IRR must be greater than this %.
Summary of IRR:
- Gives a % return figure.
- Allows for timing of cashflows
- Less flexible than NPV
- Does not tell us the scale of the investment.
Evaluation of IRR:
- Takes account of risk, timing and returns.
Main disadvantage, won’t work with investments which have ‘non-conventional’ cashflows.
IRR leads to favour investments which offer returns in the shorter term. This leads to short-termism.
Also, inadequate for evaluating new technology investments as they are unable to evaluate non-quantifiable issues.
