3.3.2 Investment Appraisal

Theme 3 Business ( Paper 2)

Investment Appraisal

Attempts to determine the value of capital expenditure projects.

Planning process

This is used in IA to determine whether the long term investments will give the best return

Simple Payback

Assesses how long it takes to the nearest years and months for returns on an investment to cover all total costs of that investment.

Payback period

Calculation of the amount of time it is expected an investment will take to pay for itself.

Payback period formula

Payback period = Initial outlay / net cash flow per period = years or months.

Initial payback

To find out how many months in initial payback after the last full year: (Difference / base)*12.

Advantages of Initial payback method

Simple method to calculate and understand; useful when business cashflow management is vital.

Disadvantages of initial payback method

No insight into the profitability of investments; payback only considers the total length of time to recover an investment.

Average rate of return (ARR)

Compares the average profit per year generated by an investment with the value of the initial outlay.

ARR formula

ARR = (average annual return / initial outlay) *100.

Total return formula

[(Total return - cost) / no. of yrs] / cost *100.

Advantages of ARR

Considers all net cash flows generated by an investment over time; easy to understand and compare the percentage returns with each other.

Drawbacks of ARR

Ignores the timing of those cash flows; the opportunity cost of the investment is ignored.

Net Present Value (NPV)

A financial metric used to evaluate the value of an investment or a project.

NPV calculation

The present value of future cash inflows - present value of future cash outflows.

Discounting method

Takes into account the fact money received in the future is worth less than money received today (inflation).

NPV investment evaluation

If future net cash flows - the initial investment = positive, the investment is worthwhile; if negative, the investment is not worthwhile.

Advantages of the NPV method

Considers the opportunity cost of money; discount tables are used to calculate the forecasted future values of net cash flows.

Disadvantages of the NPV method

It is more complicated to calculate and interpret than other methods; accurately forecasting future cash flows is a primary challenge.