Investment Appraisal

• what are the three investment appraisal techniques?

  • payback period
  • average rate of return
  • net present value
• how do you calculate simple payback period, if the annual net cash flows are constant?

  initial investment / net cash flow per period
• if the annual net cash flows are not consant, how do you calculate the remaining months for the payback period?

  amount left to return / net return of next year x 12
• how do you calculate average rate of return?

  average annual return / initial investment x 100
• when calculating average rate of return, how do you calculate average annual return?

  total net return / number of years
• what are the steps to calculating the net present value?

  • multiply each net result by each corresponding discount factor
  • add up all new discounted values to get the NPV
• identify two benefits of the payback method

  • simple to calculate and understand
  • the business can identify the point at which an investment is paid back and contributing positively to cash flow
• identify two drawbacks of the payback method

  • provides no insight into the profitability of investments
  • does not consider the future value of cash inflows, so may encourage a short termism approach
• identify two benefits of the ARR method

  • considers all net cash flows generated by an investment
  • easy to understand and compare percentage returns with each other
• identify two drawbacks of the ARR method

  • relies on averages so ignores timing of cash flows
  • opportunity cost is ignored
• identify two benefits of the NPV method

  • considers the opportunity cost of money
  • discount tables are used to calculate forecast future values of net cashflows
• identifiy two drawbacks of the NPV method

  • more complicated to calculate
  • very difficult to accurately predict future discount rates