lecture 1 sem 1 (not finished)

Investment Appraisal — definition

The process of deciding whether an investment (new machinery,new factory) is worthwhile and needs a way of deciding how to choose between different investment options.
investment appraisal provides the tools to help make this decision.

Four investment appraisal techniques

1. Payback Period (PP).

2. Accounting Rate of Return (ARR).

3. Net Present Value (NPV).

4. Internal Rate of Return (IRR).

Cash flow vs accounting profit in investment appraisal (idk what this means)

Cash flow-based techniques measure cash flows, NOT accounting profit. Depreciation is NOT a cash flow — it is an accounting adjustment and must not be included.Cash flows are assumed to occur either immediately (T0) or at the end of a period (T1, T2, T3, etc.).

Payback Period (PP) — definition

Simply : The amount of time needed for a project to repay the original cost.

Formula: there isn’t one-just add the accumulative amount the project brings in until it reaches the initial cost of the investment-the year it makes it back is the payback period year. Choose the option with the shortest payback period.

Payback Period — weaknesses

1. Payback Period is useful for businesses that need their money back quickly (small business), but it ignores profits earned later have less value due to inflation and ignores the fact that money received sooner is more valuable as it can be invested immediately

Accounting Rate of Return (ARR)

What is shows: the average annual profit generated from an investment (not how long it takes to make the money back on an investment.) compared to the initial cost of the investment
Formula(s):ARR=(average annual profit/average investment)X100 (expressed as a %- compared to the initial cost of the investment)

ARR — formula

ARR = (Average annual profit ÷ Average investment) × 100%

ARR — Average annual profit formula

(Total cash flows − Total depreciation) ÷ Life of investment. Equivalently: Total profit after depreciation ÷ Life of investment.

ARR — Average investment formula

(Initial cost + Residual value) ÷ 2

ARR — weaknesses

1. Uses profit, not cash flows. 2. Ignores the time value of money. 3. More judgemental — ARR is significantly affected by how the capital invested figure is calculated.

Time Value of Money — definition

The concept that money is worth more if received now than in the future, because of: (1) investment opportunity cost, (2) the effect of inflation, (3) risk and uncertainty of future cash flows.

Future Value formula

Future Value = Present Value × (1 + discount rate)ⁿ

Present Value formula

Present Value = Future Value ÷ (1 + discount rate)ⁿ

Discounted Cash Flow (DCF) techniques

NPV and IRR are both DCF techniques — they adjust for the time value of money by discounting future cash flows back to their present (current) value.

Net Present Value (NPV) — decision rule

If NPV > 0, the investment returns more than the required rate and will increase investor wealth — accept the project.

NPV — what the discount rate represents

The minimum acceptable rate of return for the investor.

NPV — strength

Allows for the timing of cash flows by discounting each cash flow at the appropriate period.

Internal Rate of Return (IRR) — definition

The discount rate at which the NPV of a project equals zero. It establishes exactly what rate of return the investment offers.

IRR — formula (interpolation)

IRR = A% + [NPV at A% ÷ (NPV at A% − NPV at B%)] × (B% − A%). Where A% = lower discount rate (positive NPV) and B% = higher discount rate (negative NPV).

IRR — weaknesses vs NPV

1. Less flexible and arguably less meaningful than NPV. 2. Gives a % return figure only — does not indicate the scale (size) of the investment.