F105ECO Investment Appraisal

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Common in practice 'Time Blind appraisal'

NAR -Net Annual Revenue

Total inflow v total outflow 'give a crude rate of return' by ignoring the timing of payments and receipts

Payback- uncertain future cashflows or where quick exit may need to be employed

Cutoff- Project where there is uncertainty unprotected patent, political uncertainty

Comparative costs of initial investments - where capital is limited

  • do not consider yields after payback period or the timings of the yields
  • not allow for the time value of money
  • ignores profit after payack

 

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Discounted cash flow 'DCF'

present value = converting future inflow and outflow of money into now money

DCF emphasises the importance of timings of payments and receipts through the life of the project it takes into account the uneven spread of these factors, money is worth less in the future, tax payable, grants, allowances can be built in

gnerally The project with the larger NPV will be the one to take forward

with a NPV of 0 consider that it may for non profit organisations (borrowed money) if own money investor has to feel comfortable

A flaw in NPV is that naturally larger capital investments will show a larger profit

IRR=Discount rate= capitilisation rate: at what percent is NPV=0

indicates rate of return the investor receives from his investment; it allows for cross investment analysis and measures finacial attractivness of the investment

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Establishing the rate of discount

Borrowed money = use rate at which the money can be borrowed

Own Money= use rate that can be acheived by investing into alternative investment eg government bonds. the investor will require to use judgement on the what rate he is comfortable with - anticipated risk of the project' all circumstances need to be considered

these methods are useful tools for financial evaluation

not all satisfaction can be measured in monetary form

no substitute for sound judgement

Formula for discounting (present value)

PV=1/(1+i)n

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Building risk into a project

risk can built into All but the riskiest projects (which can use the cut off method of appraisal)

Distinction between risk and uncertainty, risk has a probability distribution

uncertainty ie change in consumer behaviour

an example being

in gerneral risk and uncertaity can be be built in as a risk premium added to the discount rate

  • it penalises distant returns (naturally)
  • risks are not constant each year
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