Investment Appraisal theory

Why is it necessary for firms to use investment appraisal?

In order to work out if they can afford major Equity Investments

What are the 2 methods of Investment Appraisal?

ARR and Payback Period method

What is the difference between ARR and the Payback period method?

ARR shows the annual rate of return generated by the investment whereas the Payback method shows how long it will take to payback the investment cost

2 Advantages of ARR

Identifiable and familiar profitability ratio for managers with limited financial training, easy to calculate

2 Disadvantages of ARR

There is no target rate of return, may lead to a firm choosing a project which only has a higher profit in its earlier years

2 advantages of Payback period

East to understand and calculate, considers cash flows rather than the project

2 disadvantages of Payback period

Ignores profitability, ignores time value of money

Why might managers using payback period may be drawn to short term investments?

the firm will get their initial investment back faster

What’s a disadvantage of both ARR and payback period method?

ignores the need to make a profit