Business Studies - Investment Appraisal

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.

Advantages:

• 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.

Disadvantages:

• 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.

The total accounting return for a project to see if it meets the target return.

To calculate:

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.

 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.