3.8 Investment Appraisal

Investment Appraisal

Process of quantifying the financial risks of an investment decision

Define payback period

Time is takes for a project to repay its initial investment

PBP formulas

• COI ÷ CPM

• IIC ÷ ACFPY → in years

• IIC ÷ (ACFPY ÷ 12) → in months

Steps to find PBP

1. Find cumulative for each result in the year table

2. Find where the money is paid in full and profit is made, take the year within, not after!

3. Divide the actual amount of the next year, divide these

4. Multiply answer by 12

Advantages of PBP

• Easy to calculate

• Understood by non-accountants

• Helps make decisions in rapid changing markets

Disadvantages of PBP

• Ignores revenue/costs after payback

• Doesn’t take into account inflation

• Based on predictions which could be wrong

Define Average Rate of Return

Total accounting return for a project to see if it meets the target return (higher the value, the better)

Stages in calculating ARR

• Add up all positive cash flow (cumulative)

• Subtract cost of investments

• Divide by life span

• Calculate the % return to find ARR

Advantages + Disadvantages of ARR

• Advantages

  • Focuses on profitability

  • Provides a percentage

• Disadvantage

  • Doesn’t take in to account cash flows

  • Takes no account of inflation

Explain PBP in terms of high number, low number and decision

• High: Slower recovery of investment, higher risk, less attractive

• Low: Faster recovery, lower risk, better liquidity

• Decision: Prefer projects with a low payback period for quicker returns

Explain ARR in terms of high number, low number and decision

• High: Indicates high profitability, attractive to investors

• Low: Lower returns, less appealing, potential opportunity cost

• Decision: Favour projects with a high ARR for better returns

Define Net Present Value

Monetary value now of project’s future cash flows

Steps to find NPV

1. Multiply discount factors by the cash flows

2. Sum/Add the discounted cash flows

3. Subtract original cost to get NPV

NPV Formula

∑ total present values - original cost

Discounted Rate

Figure used to reduce future value of money

Advantages of NPV

• A way a decision can be made in today’s monetary value

• More realistic than ARR

• More informed comparisons between projects

Disadvantages of NPV

• Difficult to predict future net cash flows

• NPV is more difficult and time consuming to calculate

• Discounts can be subjective at times

Explain NPV in terms of high number, low number and decision

• High: Strong profitability, adds value, reduces risk

• Low/Negative: Less value, potential loss, higher risk

• Decision: Choose projects with a high NPV for maximising value