Investment Appraisal

Involves comparing the expected future cash flows with the initial outlay for that investment.

Payback:

The amount of time it will take for an investment to pay for itself.

Net cash flows are expected to be a constant over time.

initial outlay/net cash flow per period

cash still to be recovered/cash generated in the next year x 12

Multiply a decimal by 12 to convert it into months.

Benefits of payback:

  • Helps cash flow management

  • Can identify the point when an investment is paid back and contributing positively

  • Useful where new technology is introduced regularly - has the investment paid itself back yet?

Drawbacks of payback:

  • No insight into profitability

  • Inaccurate

  • May encourage short-termism

  • Good investments may be dismissed as they take longer to pay back than others.

Average Rate of Return:

How much return from an investment is received.

average annual return/initial investment x 100

Advantages of ARR:

  • Considers all net cash flows generated

  • Easy to compare

Disadvantages:

  • Fails to take timing into account

Net Present Value:

  • Evaluates the value of an investment

  • Takes into account effects of interest rates

  • Discounting method

Multiply the year’s net cash flow by the discount factor.

net cash flow x discount factor - initial investment

Advantages of NPV:

  • Considers interest

  • Can forecast future values of net cash flows

  • Businesses can choose different discount factors to adjust level of risk

Disadvantages:

  • More complicated to interpret

  • Can’t accurately forecast or choose appropriate discount rate

  • Only considers financial costs and benefits of a project

What changes all these?

  • Unexpected increases in costs

  • New competitors

  • Changes in consumer tastes

  • External shock

  • Economic growth/recession