IB Business 3.8 Investment Appraisal

what is an investment

The purchase of an asset (capital good or expenses) with the potential to yield future financial befits

what is an investment appraisal

is the quantitative (means in this case dealing with numbers) technique used to calculate the financial costs and benefits of an investment decision

what are the two main appraisal methods

1. Payback period

2. Accounting rate of return

what is quantitative

dealing with numbers techniques used to calculate the financial costs and benefits of an investment decision

Qualitative invest decision can be remember by the mnemonic PORCHE

Predictions-gut feelings

Objectives

Risk Profile

State of the economy

Corporate image

Human Relations

Exogenous shocks

what is the payback period

it is the period of time for an investment to earn enough profits to repay the cost of the invest

what is the formula for payback period

initial investment/ contribution per month

payback period advantages

-Quick and easy to use.

-Useful if your firm has a cash

flow problem.

-Allows you to see the break-even

on the purchase before it needs to be replaced.

-Used to compare different

investments: looking for the

quickest payback period.

-Asses projects that yield quick

returns (profits) for investors.

-Assess the short term, less

forecasting errors.

payback period disadvantages

-May cause short-termism: you

may focus only on short term

investments.

-Monthly contributions will vary

and will not be constant.

-This method focuses on time

and not on profits...which is

the major aim of most

businesses.

what is the accounting rate of return

this method calculate the average profit on an investment as a % of the amount invested

the formula of accounting rate of return

(total profits during projects (revenue-instal investment)/number of years of projects projected X 100)/initial amount invested

Why is this useful

-The ARR allows you the manager, to compare the rates of returns on other

investment projects.

-Used to assess the risks and rewards involved in an investment.

-For example: if an APR is 12% on a project vs. 4% in interest rate on savings, the real rate

of return is 8%. So it might be worth the risk to invest on the project vs. to saving your

money.

-Turn to page 353 in your text for another example on how to

calculate ARR.

advantages of accounting rate of return

-Enables easy comparisons of

different investment projects.

-You are looking for the

investment which provides the

most return for less money

invested.

disadvantages of accounting rate of return

it ignores the timing of cash inflows

-prone to forecasting errors

Constant vs. Cumulative

when income is not constant, payback must be determined using the cumulative cash flow method