3.3.3.2 Investment Appraisal

Define investment appraisal

the planning process used to determine whether the long term investments will give the best return

use of numerical techniques to predict financial outcomes of investments

may be used to compare different options or against predetermined criteria

Projects such as:

• new machinery

• premises

• R&D projects

Define investment

process of using money with a view to future profit or material gain

What is payback?

the calculation of how long it’ll take to pay back the cost of initial investment

the longer the payback period, the greater the degree of risk and uncertainty

need to also consider how the investment is being funded (via bank loan, what’ll be the impact on gearing?)

doesn’t take into account what happens after payback

assumes that in the yr of payback that the cash inflow is equal each month

What are the advantages of payback?

• simple n easy to calculate n easy to understand results

• focuses on cash flow - good for use by businesses where cash is a scarce resource

• emphasises speed of return ; may be appropriate for business subjects to significant market changes

• straightforward to compare competing projects

What are the disadvantages of payback

• ignore cash flows which arise after the payback has been reached (doesn’t look at overall project return)

• takes no account of the ‘time val of money’ (bling bling)

• may encourage short term thinking

• ignores qualitative aspects of a decision

• doesn’t actually create a decision for the investment

What is the formula for average profit?

total net cash flow / no. of yrs

What is the formula for average accounting rate of return (ARR)?

avg annual profit / initial investment x 100

doesn’t consider time value of money - when will profit come back (yr 5?)

What is discounted cash flow

calculates the total return on investment taking into account the time val of money

it discounts the return each yr to recognise that 1 quid today isnt the same in 3 yrs time using a discount factor

What does a positive net present value imply?

a worthwhile investment

What is an investment criteria

Predetermined set of guidelines against which an investment can be judged

Min targets expected from investments

What is the difference between risk and uncertainty?

Risk can be calculated whereas uncertainty cannot be predicted

Things to consider in assessing the degree of risk/uncertainty are…

• Gearing

• Stability

• Opportunity costs

• Prediction

• Competitor reactions

• Time frame

Investment appraisal is trying to minimise risk or help inform decision making

List 2 limitations of ARR

• Doesn’t take cash flows into account - only profits

• doesnt take into account the time val of money

List 2 limitations of NPV

• the calc is more complex than other methods

• rate of discount is critical - if high 🌿, fewer projects will be profitable

List 4 limitations of payback

• Cash earned after payback is IGNORED

• Profitability of methods is overlooked

• Doesn’t take into account the time value of money (bling bling)

• May encourage short term thinking