- Created by: Keana19
- Created on: 15-04-18 22:42
The process of analysing whether investment projects are worthwhile.
The time it takes for the project to repay its initial investment.
To calculate: Work out the cumulative cash flow until the money is paid back. Then to work out the year payback occurs, you do: amount still outstanding divided by inflows' year of payback.
- Simple and easy to calculate + easy to understand the results.
- Focuses on cash flows – good for use by businesses where cash is a scarce resource.
- Emphasises speed of return; may be appropriate for businesses subject to significant market change.
- Straightforward to compare competing projects.
- Does not actually create a decision for the investmentIgnores qualitative aspects of a decision.
- May encourage short-term thinking.
- Takes no account of the "time value of money".
- Ignores cash flows which arise after the payback has been reached – i.e. does not look at the overall project return.
Average Rate of Return
The total accounting return for a project to see if it meets the target return.
1) Add up all the inflows.
2) Calculate profit = inflows - investment.
3) Divide the profit by the life of the investment.
4) Calculate percentage: profit over life / initial investment.
- + Simple to understand and easy to calculate.
- + Focuses on the overall profitability of an investment project.
- + Easy to compare ARR with other key target rates of return to make a decision.
- + Use all returns generated by a project.
- - No indication of the payback period.
- - The life of the investment project needs to be known.
- - Focuses on profits rather than cash flow.
- - Does not adjust for the time value of money.
Net Present Value
NPV calculates the monetary value now of a projects' future cash flows. Discounting - a method used to reduce the future value of cash flows to reflect the risk that may not happen.
To calculate: Work out the present value by doing cash flow x discount factor.
A positive NPV for a project suggests that the investment project should go ahead and a negative NPV would suggest that a project should be rejected.
- + Considers all future cash flows.
- + Reflects the risks that future cash flows will not be as expected.
- + Different levels of risk can be accounted for by adjusting discount rate.
- + Creates a straightforward decision - positive NPV suggest the project should go ahead.
- - The most complicated method compared with payback and ARR.
- - Choosing the discount rate is difficult, particularly for long projects - often an educated guess.
- - Results can be influenced/manipulated using the discount rate.