3.8 Investment Appraisal

investment definition

the purchase of an asset with the potential to yield future financial benefits

investment appraisal definition

Quantitative techniques used to assess the risks involved in investment decision-making

Calculate the financial costs and benefits of an investment decision

what are the three methods

Payback period

Average rate of return - formula given ☺

Net present value - formula given ☺

payback period

amount of time needed for an investment project to earn enough profit to repay the initial cost of the investment

payback period formula

initial investment cost/contribution per month or per year

payback period workout

contruct table - x year something, shortfall at end of x year (right), calculate the average monthly cashflow of the next year (left), diide shortfall by monthyly cash flow

Is a longer or shorter payback period desired? Why?

Shorter!

It takes less time to recover the costs of the project

Payback period (PBP)

Advantages

Simplest and quickest method of investment appraisal

See whether investments will break-even before an asset needs to be replaced

Identify how long it would take for the cash to be recouped —> useful for firms with cash flow problems

Compare different investment projects with different costs by calculating the quickest PBP of each option

It helps to assess projects which will yield a quick return for shareholders.

Average rate of return (ARR) definition

Calculates the average profit on an investment project as a % of the amount invested

Is a higher ARR or lower ARR better?

higher

ARR can be compare against

interest rate

if it’s higher than interest rates, it would be a worthwhile investment

ARR advantage

Enables easy comparisons (in percentage terms) of the estimated returns of different investment projects.

If two projects are predicted to yield the same ARR, then the relatively cheaper project might be more desirable given that it carries less financial risk.

Average rate of return (ARR) Disadvantages

Ignores the timing of cash inflows and hence is prone to forecasting errors when considering seasonal factors.

The project’s useful life span (which might be a pure guess) is needed before any meaningful calculations can be made.

What is porsche

predictions obhectives risk profile state of the economy corporate image human relations exogenous shocks

PBB disadvantages

contribution each month unlikely constant

only encourages short time - might ignore long term

prone to error