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Flashcards in Investment Appraisal Deck (20)
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Investment appraisal

Evaluating the profitability or desirability of an investment project


Net cash flow calculation

inflow - outflow


Payback period

length of time it takes for the net cash inflows to pay back the original capital cost of the investment


Payback period calculation

Payback period = (income required / next year net cash flow) x 12

* Calculate cumulative cash flow
Cumulative = the next cash flow + cumulative cash flow

*start with year 0


Advantages of payback period (4)

- Quick and easy to calculate
- Easy to understood
- The result can be used to eliminate projects that give returns too far into the future
- Useful for business where liquidity is of greater significance than overall profitability


Disadvantages of payback period (3)

- Does not make sure the overall profitability of a project (ignores all the cash flow after the payback period)
- This concentration on the short term leads businesses to reject very profitable investments just because they take some time to repay the capital
- Does not consider the timing of the cash flow during the payback period (external factors: economic recession)


ARR - Average rate of return

Measures the annual profitability of an investment as a percentage of the initial investment


ARR calculation

(annual profit (net cash flow) / initial cost ) x 100

Average profit: (total profit - cost of investment) / no. years


Advantages of ARR (4)

- Uses all of the cash flows - unlike the payback
- Focuses on profitability, which is the central objective of many business decision
- The result is easily understood and easy to compare with other projects that may be competing for the limited investment funds available
- The result can be quickly assessed against the predetermined criterion rate of the business


Disadvantages of ARR (3)

- Ignores the timing of the cash flows (can result in two project with similar ARR, but one could pay back more quickly than another)
- Later cash flow are less likely to be accurate are incorporated in the calculation (as all the cash flows are included)
- The time value of money is ignored as the cash flows have not been discounted


NPV - Net present value

Today's value of the estimated cash flows resulting from an investment


Advantages of NPV (3)

- Considers both the timing of cash flows and the size of them in arriving at an appraisal
- The rate of discount can be varied to allow for different economic circumstances. (increased if interest rate is expected to rise )
- Considers the time value of money and takes the opportunity cost of money into account


Disadvantages of NPV (3)

- Complex to calculate and to explain (to non numerate managers)
- The final result depends greatly on the rate of discount used, and expectations about interest rates may be inaccurate
- Can only be compared to other project only if the initial capital cost is the same. (because the method does not provide a percentage rate of return on the investment)


IRR - Internal rate of return

The rate of discount that yields a net present value of zero - the higher the IRR, the more profitable the investment of the project


Criterion rates of levels

The minimum levels (maximum for payback period) set by management for investment - appraisal results for a project to be accepted


Advantages of IRR (3)

- Giving a percentage rate of return, different projects costing different amounts can be compared.
- The IRR is easily compared with the rate of interest or the criterion rate of business
- It avoids the need to choose an actual rate of discount


Disadvantages of IRR (2)

- The calculation is tedious without a computer
- By giving an exact result, it can mislead business users into believing that investment appraisal is a precise process without risk and uncertainties


What does it meant by "present value" in of future profit from an investment

Net present value is today’s value of the estimated cash flows resulting from an investment.

Due to inflation, the cost of asset varies, which leads to the increases in cost of asset causes the present value to be reduced


NPV calculation

NPV = present value of return – cost

Present value = revenue or profit of ... years x discounted number from given table


Quantitative methods of investment appraisal does not show the full picture, what does the business has to consider as well?


P = prediction (interest rate, income levels)
O = objective
R = risk
S = State of economy
C = Corporate image
H = Human relation (redundancies, recruitment)
E = Environmental factor (natural disaster)