Week 5- Investment appraisal, payback, IRR, NPV` Flashcards
What are the methods of investment appraisal?
1- NPV (Net Present Value)
2- IRR (Internal Rate of Return)
3- PI (Profitability Index)
4- ARR (Accounting Rate of Return)
5- PP (Payback Period)
What are the advantages of using ARR?
1- Easy to understand
2- Good way to monitor profitability
What are the disadvantages of using ARR?
1- Does not use cashflows
2- Takes no account of the size of the investment
What is PP?
Payback period is the number of years needed to recover the original investment from the cash flows.
What are the advantages of using the PP method?
1- It is simple to understand
2- It provides an indication of risk
What are the disadvantages of using the PP method?
1- It ignores the cash flows beyond the point of payback
2- It ignores the timing of cash flows over the payback period
What is compounding?
Compounding takes us forward from the current value of an investment to its future value.
What is discounting?
Discounting takes us backward from the future value of a cash flow to its present value.
What is the NPV?
The discounted or present value of the activity after meeting all finance charges.
What are the advantages of NPV?
Takes account of the time value of money
Takes account of all cash flows during the project
What are the disadvantages of NPV?
- Difficult to estimate cash inflows and outflows over the life of a project
- Cost of capital may be difficult to determine and may change over the life of the project
What is IRR?
Is the maximum cost of capital which can be applied to finance a project without causing harm to the shareholders.
What are the advantages of IRR?
- Allows for the time value of money
- All cash flows are taken into account
What are the disadvantages of IRR?
Results depend on the quality of the cash flow forecasts
Ignores the scale of the investment
What is PI?
The ratio of the present value of project benefits to the present value of initial costs.
