Business Paper 2 - Investment Appraisal (209)

Investment Appraisal

a technique used to evaluate planned investment by a business and measure its planned financial value to the business

it will then mostly compare one investment opportunity against another to decide which offers the best overall value to the business

• Payback Period

• ARR

• NPV

Payback Period (Advantages + Disadvantages)

the amount of time it would take for a business to recover a project's initial cost

formula: number of full years & (Amount Needed final year / Amount Getting in final year) X 12

Advantages:

• simple to use + easy to calculate

• effective to use when technology is changing at a fast rate, such as hi tech projects, in order to recover the cost of investment as quickly as possible

• helps with managing cash flow

Disadvantages:

• ignores flows of cash over the lifetime of the project

• ignores total profitability, the focus is just on the speed to which the initial outlay is repaid

Average Rate of Return (ARR) (Advantages + Disadvantages)

this measures the average annual profit as a percentage of the initial investment

formula: average annual profit / cost of investment x 100

Advantages:

• shows the profitability of the option/project Includes all the project's cash flows

• easy to compare different projects

• allows comparison with costs of borrowing for investment

Disadvantages:

• ignores the timing of the cash flow

• does not allow for effects of inflation on values of future cash flows

Net Present Value (Discounted Cashflow) (Advantages + Disadvantages)

this takes account of the ‘time value of money’ which recognises that e.g. £1 earned in five years’ time is not the same as £1 earned today. It shows how much an investment is worth throughout its lifetime, discounted to today’s value

formula (steps):

• multiply amount by discount factor

• add all together

• minus the initial cost from this

if NPV is positive, the project is worthwhile - choose the highest NPV if having to calculate two

Advantages:

• easy to compare different projects

• allows for impact of inflation on value of future cash flows

• discounts can be changed to take into account changes in the economic and financial climate

Disadvantages:

• it is difficult to calculate

• discount factors could be incorrect which makes the NPV inaccurate

• difficult to set discount factors far into the future, the longer into the future we go the less reliable the discount factor

Qualitative factors affecting investment appraisal decisions

• Impact on staff. Can staff handle the changes brought about by investment? Can staff be trained to use new technology? Will there be redundancies as a result of the investment?

• Action of competitors. Are they investing/ improving their products?

• Is there sufficient funding available to invest in the project? Would the investment put

  the business at risk by reducing cash flow or increasing borrowing?