7.8 Investment Appraisal

Payback Period

• time it takes for an investment to generate enough cash flow to recover its initial cost

• number of full years + (additional cash flow needed to reach payback / cash flow in the next year.

• 2 years and (5000 / 20000 = 0.25) 0.25 × 12 = 3 months

DIS payback period

• returns are a prediction - risk involved

• opportunity cost such as putting money in the bank

• inflation - better to have money sooner

• equipment can become obsolete so its better to have returns sooner

• disregards returns after payback period so its hard to measure total profitability

• hard to present to investors as its not a percentage

advantages of payback period

• focuses on cash flow – useful for cash-limited businesses

• helps reduce risk – by favouring projects that pay back quickly

• good for short-term planning

• useful in uncertain environments – where long-term predictions are hard

• helps compare projects – especially when time to recover investment is important

Average rate of return

• calculates the percentage return expected on an investment based on the average annual profit compared to the initial cost

• net return / number of years = average return

• average return / initial cost x 100

ADV ARR

• can be compared with other financial returns

• uses returns from all years

DIS ARR

• ignores time value of money – doesn’t consider that money today is worth more than in the future

• based on accounting profits, not cash flow – can give a less accurate view of actual returns

• affected by accounting policies – like depreciation methods, which can distort results

• doesn't show how long it takes to recover the investment

• not suitable for comparing projects with different lifespans

Net present value

• calculates the current value of the net return from an investment after discounting the opportunity cost

• net cash flow for each year x discount factor = annual net cash flow

• add all discounted annual net cash flow

• take off the original investment

DIS NPV

• too high a discount factor may have been chosen

• investment may not last as long

• risk element

• estimates may be too optimised

value of sensitivity analysis

• way to test “what if” scenarios to understand risks and make better choices

• shows how results change when key assumptions change

• helps identify which variables have the biggest impact

• improves decision-making under uncertainty

• tests how risky or stable a project or plan is

• supports better forecasting and planning

• increases confidence in financial and strategic decisions