Unit 3.8 investment appraisal Flashcards
The average rate of return (ARR)
The average rate of return (ARR) calculates the average annual profit of an investment project, expressed as a percentage of the initial amount of money invested.
The cumulative net cash flow
The cumulative net cash flow is the sum of an investment project’s net cash flows for a particular year plus the net cash flows of all previous years.
discount factor
A discount factor is the number used to reduce the value of a sum of money received in the future in order to determine its present (current) value.
Discounted cash flow
Discounted cash flow uses a discount factor (the inverse of compound interest) to reduce the value of money received in future years because money loses its value over time.
Investment
Investment refers to capital expenditure or the purchase of assets with the potential to yield future financial benefits.
Investment appraisal
Investment appraisal is a financial decision-making tool that helps managers to determine whether certain investment projects should be undertaken based mainly on quantitative techniques.
Net present value (NPV)
Net present value (NPV) calculates the total discounted net cash flows minus the initial cost of an investment project. If the NPV is positive, then the project is viable on financial grounds.
The payback period (PBP)
The payback period (PBP) is an investment appraisal technique that calculates the length of time it takes to recoup (earn back) the initial expenditure on an investment project.
The principal (or capital outlay)
The principal (or capital outlay) is the original amount spent on an investment project.
Qualitative investment appraisal
Qualitative investment appraisal refers to judging whether an investment project is worthwhile through non-numerical techniques, such as determining whether the investment is consistent with the corporate culture.
Quantitative investment appraisal
Quantitative investment appraisal refers to judging whether an investment project is worthwhile based on numerical (financial) interpretations, namely the PBP, ARR and NPV methods.
advantages of PBP
- The PBP is the simplest and quickest method of investment appraisal; hence, it is the most commonly used method.
- The PBP method can be useful for firms with cash flow (liquidity) problems as they can identify how long it would take for the cash investment to be recouped.
- It allows a business to see whether it can break-even on the purchase of an asset before it needs to be replaced. This can be important in today’s fast-paced business environment.
- The payback period can be used to compare different investment projects with different costs by calculating the quickest PBP of each option.
-The PBP method helps managers to assess projects that will yield a quick return for shareholders.
Disadvantages of PBP
- The contribution per month is unlikely to be constant as demand is prone to seasonal fluctuations so the PBP might take longer.
- PBP focuses on time as the key criterion for investment, rather than on profits - the main objective of most private sector businesses.
- It can encourage a short-termism approach to investment, i.e. managers only focus on the short term benefits and ignore the potential gains in the longer term.
- PBP might not be highly suitable for some business; property developers and cruise liner operators are unlikely to recoup their investments for many years.
-Calculations of the PBP are prone to errors as it is difficult to predict future cash flow figures accurately.
PBP calculation
initial invesment cost ($) / contribuation per month ($)
average rate of return calculations
(total profit during projects lifespan/number of years of projects)/inital amount invested ($) x 100
