Business Studies - Investment Appraisal

  • Created by: Keana19
  • Created on: 15-04-18 22:42

Investment Appraisal

The process of analysing whether investment projects are worthwhile. 

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Payback Period

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.
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Average Rate of 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.
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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.
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