3.8 Investment Appraisal

investment appraisal

a qualitative and quantitative desicion making tool used to asses whether the capital expidenture of a firm is justifiable in terms of whether it will be financially worthwhile

payback period

method of investment appraisal that measures the esitmated time it will take for an investment project to make enough profit to cover the inital cost of the project. it allows a firm to see if they will reocver the cost of the nc assets before it needs to be replaced. the larger the annual net cash flow the higher the pbp. a poject is usually desirable if its pbp is short, but depends on industry norms

which firms is pbp suitbale for

• regard liquidity as more important than profitability

• focus on time as a priority for investments

• want a quick return on ivestment

when do u use the formula to calculate pbp

only when cash flow is the same monthly

formula for pbp

cost of investment/contribution per month

what mehtod do you use if cash flow is NOT the same every month

contribution method

advantages of pbp

• simplest and quicket way of investment apprasial to calculate

• easy for managers to interpret and understand results

• depreciation of non current assets doesnt directly affect pbp but can be easily included into the calc

• helps managers choose investments with short pbp to reduce risk

disad of pbp

• ignores timing of net cash flows despite the future value of cash being lower

• not really suitable for long term projects

• time rather than profitability is the focus which can be unrealistic for some private firms

• doesnt include useful time of the nc asset after its pbp

avg rate of return

measures the annual prift generated from an investment project, expressed as a % of the initial cost

more info on ARR

• its compared to the firms desired rate of return to determine whether to accept or reject the investment proposal. this is often based on the prevaling intrest rate in the economy and/or the predicted ARR for other proposed investment projects

• the higher ARR, the more financially attractive a project is

adv of arr

• simple to udnerstand and straightforward to calculate

• unlike pbp arr focuese on profitability, not time

• firm can use arr to evaluate its financial performance

• arr is a percent which can b useful to determine attractiveness of a range of different investment projects

disad of ARR

• focuses on profit rather than cash flow in order to break even quickly and generate cash to invest in other projects

• figures are predictions only so they tend to be less accurate the longer the investment project under consideration is

NPV

teq that calculates the real value of an investment project by discounting the value of future cash flows. once the initial cost of the investment project is decucted from the total discounted cash flow, npv is found. higher npv is more attractive

discount rate

the number used to reduce the value of a sum of money recieved in the future in order to determine the present value. opposite of a compund intrest rate

adv of npv

dias of npv

qualitative aprraisal (porchse)

p - predictions

o - objectives ex.csr, profit, growth

r - risk proflie (risk takers or not)

s -

when choosing you investment which factors do u condier

quantative and qualitative