Flashcards in UNIT 5. Chapter 33. Investment appraisal Deck (15)
Def. Investment appraisal
Evaluating the profitability or desirability of an investment project
What information about an investment project is necessary for quantitative appraisal?
• Initial capital costs
• The estimated life expectancy
• The residual value of the investment
• The forecasted net returns
What are the five quantitative methods of investment appraisal?
• Payback period
• Average rate of return
• Discounted payback
• Net present value
• Internal rate of return
Def. Payback period
Length of time it takes for the net cash inflows to pay back the original capital cost of the investment.
= (Income required/ Following year's net cash flow) x12 + all of the years before
Why are long payback periods not favourable (4)
• Increases interests payments
• There is opportunity costs of the capital
• The whole investment becomes more uncertain, increases the amount of risk
• Cash flows received in the future are of less value due to inflation
Advantages and Disadvantages of the payback period (4 3)
• Quick and easy to calculate
• Easily interpreted by managers
• Beneficial for business with liquidity concerns
• Allows focus for short term profitability
• Doesn't measure the overall profitability of the project
• Doesn't consider the timing of the cash flows
• May make businesses defer much more profitable projects but take longer to repay capital
Def. Average rate of return
Measures the annual profitability of an investment as a percentage of the initial investment.
ARR (%) = (Annual profit/ Initial capital cost) x100
Ad. and Disad. of ARR (3 2)
• Focuses on profitability
• Easily understood
• Uses all of the cash flows - unlike payback period
• Ignores the timing of cash flows
• Does discount the value of past cash flows (due to inflation)
How is discounting done?
• The higher the interest rate, the less value future cash have in today's money
• The longer into the future cash is received, the less value it has today
(There's a table that provides the factor of discount)
Def. Net present value
Today's value of the estimated cash flows resulting from an investment.
Ad. and disad. of net present value (3 2)
• Considers both the timing of cash flows and the size of them
• The rate of discount can be varied to allow for different economic circumstances
• Take the opportunity cost of money into account
• Complex to understand and explain
• Expectations about interest rate may be inaccurate
Def. Internal rate of return (IRR)
The rate of discount that yields a net present value of zero - the higher the IRR, the more profitable the investment project is.
(Can be found using a graph method pg. 600)
Def. Criterion rates/levels
The minimum levels (max for payback period) set by management for investment appraisal results for a project to be accepted.
Ad and disad of IPP (2 2)
• IRR is easily compared to the criterion rate of the business
• Different projects costing different amounts can be compared
• Calculation are tedious without a computer
• Can be misleading