Chapter 6: Making Investment Descisions

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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


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