Chapter 6: Making Investment Descisions
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- Created on: 10-12-14 10:37
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- Making Investment Descisions
- Average Rate of Return (ARR)
- a comparison of the profit generated by the investment with the initial cost of investment
- ARR % = total net return or surplus from project / no. of years / initial cost x 100
- Example = 10 / 3 / 50 x 100 = 6.7 %
- Advantages
- result can be understood by anyone
- can easily be compared with next best alternative
- shows true profitability of investment
- Disadvantages
- harder and time consuming
- considers all income and expenditure as equal
- Payback Period
- the length of time taken to repay initial capital cost
- Advantages
- easy to calculate
- concept is easy to understand
- emphasises on speed of return
- empahsises cash flow be focussing on time taken to return money
- Disadvantages
- ignores revenue or costs that occur after point of payback is reached
- does not consider overall net profit from project
- difficult to establish target payback time
- encourages short-termism
- values future costs as same as current costs
- Investment Appraisal
- a scientific approach to making investment decisions, which investigates expected financial consequences of investment in order to help choose choice in investment
- Net Present Value (NPV)
- shows what investment would have earned in alternative investment scheme
- value of money is affected by interest rates
- takes into account that value of money changes over time
- Advantages
- only method that considers time and value of money
- only method that gives precise answer
- Disadvantages
- time consuming
- difficult to calculate
- difficult to understand
- calculation is based on arbitrary choice of percentage discount rate
- Average Rate of Return (ARR)
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