Investment appraisal

Investment appraisal

  • Assessment to see if it is financially worthwhile to invest in a big project

  • Uses a variety of methods to help a business

  • Always remember to put year 0! (cash out = investment cost)

Payback

  • Working out the amount of time taken to recover the initial cost of an investment project

  • Payback occurs during year sometime during 4th year = payback = 3 years & X months

  • X months = Cummulative NCF above PB (in CNCF column) /NCF adjacent to PB

  • \frac{CMCF}{adjacentNCF}

Evaluations:

Strengths:

  • GIves financially unstable businesses options to choose the projects with the quickest payback (when having cashflow problems?)

  • PPL who don’t know finances can easily understand & interpret payback

  • Good to compare competing projects

  • In dynamic markets like tech = may need to payback projects quickly due to significant risk & rapid changes

Weaknesses:

  • Ignores duration of the whole project = doesn’t consider cashflow after payback

  • Doesn’t account for the time value of money bc value of currency will change

  • Encourages short term thinking in decision making = opportunity costs of long term benefits? (depends on cashflow maybe)

Average (Accounting) Rate of Return (ARR)

  • Total average returns of a project in % of a project annually

ARR = total NCF / years of project / initial investment

Evaluation:

Strengths:

  • Lets you compare viabilities of a project against opportunity cost/interest rates etc.

  • Easy comparisons between project options

  • Fairly easy for non-financial decision makers to understand %

Weaknesses:

  • Doesn’t account for time value of money = longer project = more distorted figures, leading to potentially misguided investment decisions.

  • Requires accurate data = needs a skilled & trained person to do ARR

Net present value (NPV)

  • Works out project’s future cashflow’s current monetary value

  • Applies discounted cash flows so impact of time value of money is accounted for

  • Positive NPV = should invest

  • Should go with the project with highest NPV %

NPV = total of each NCF x each DCF

Evaluation:

Strengths:

  • Accounts for time value of money unlike other investment appraisal methods

  • DCF can be adjusted for canges in economic conditions

  • Clear decision provided = negative dont do, positive do

Weaknesses:

  • Based on estimates = needs accurate data & skilled person = biased data

  • New/unusual products = more uncertainty = invalid figures

  • DCF rate can be inaccurate = subjective

  • Can be hard to calculate

Other considerations to make:

  • Always consider qualitative factors

  • Ethics = may impact communities? align with business goals?

  • Risk? = economic outlook, longer projects = more risk of unexpected factors

  • Availability of funds?

  • Business confidence

  • Human Relations (HR) = will investment cause redundancies or damage company culture?