Investment appraisal

• payback = Time it takes for a project to repay its initial investment.
• Payback steps =

  1. Calculate net cash flow
  2. Calculate cumulative cash flow
  3. Check when it turns positive
  4. divide the amount left by the net cash flow amount coming in the following year and the divide by 12
• Average rate of return = looks at the total accounting return for a project to see if it meets the target return.
• Average rate of return steps =

  1. Calculate the average annual profit from the investment profit
  2. Divide the average annual profit by the outlay
  3. Compare with the targeted percentage
• Net present value = process of analysing whether an investment project is worthwhile
• Net present value steps = Calculate cash flow X discount rate = Net present value
• payback limitations = Ignores cashflow after payback has been reached, no account for "time value of money" , doesn't create a decision for the investment.
• Average rate of return limitations = It does not account for different projects that might require different capital outlays, focuses on profit rather than cash flow and doesn't adjust for the time value of money.
• Net present value limitations = ignores future cash flows, can be unreliable if wrong discount rate is used and ignores opportunity cost.
• benefits of payback:

  • simple
  • It is particularly useful for businesses where the cash flow management is vital
  • Businesses can identify the point at which an investment is paid back and contributing positively to cash flow
  • It is also useful where new technology is introduced regularly
  • Businesses purchasing equipment can calculate whether an investment ‘pays back’ before an upgrade is available
• Drawbacks of payback:

  • It provides no insight into the profitability of investments
  • Payback only considers the total length of time to recover an investment
  • Neither the timing nor the future value of cash inflows is considered
  • It may encourage a short-termism approach
  • Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives
• Advantages of ARR:

  • It considers all of the net cash flowsgenerated by an investment over time
  • It is easy to understand and compare the percentage returns with each other
• Disadvantages of ARR:

  • As it depends on an average of cash flows it ignores the timing of those cash flows
  • The opportunity cost of the investment is ignored as values are nether expressed in real terms nor adjustments made for the impact of interest rates and time
• Advantages of NPV:

  • It considers the opportunity cost of money
  • Discount tables are used to calculate forecast future values of net cashflows
  • Businesses may choose different discount tables to adjust the level of risk involved in a project allowing a range of scenarios to be considered
• Disadvantages of NPV:

  • It is more complicated to calculate and interpret than other methods of investment appraisal
  • One of the primary challenges of using the NPV method is accurately forecasting future cash flow
  • Selecting an appropriate discount rate can be challenging
  • The NPV method only considers the financial costs and benefits of a project and does not account for non-financial benefits or costs