Investment Appraisal - Finance

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Payback

How long it takes for the business to get their investement back

Count the investment over the number of years, to work out the extra number of months

= (amount still owing /  the inflow from next year) x 12

Advantages:

Indicates the length of time the capital is at risk for

Important if the business has cash flow problems

Disadvantages:

If you want to make direct comparisons similar amount of start up capital must be needed

It ignores the timing of cash flows

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Accounting Rate of Return

It calculates the average return from a project expressed as a percentage of the cost of the project, so it takes into account the profitability of the project

ARR = (Average Annual Profit / Initial Investment) x 100

Step by step:

1. Add up all the inflows = total inflows

2. Total inflows - intital investment = total profit

3. Total profit / no. of years investment = Average Annual Profit

4. (Average Annual Profit / Initial Investment) x 100

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ARR Advantages and Disadvantages

Advantages:

Calculates returns without relying on using an acurate discount rate

Allows  direct comparisons of returns

Important when profitability is an issue

Disadvantages:

It doesn't account for fluctations in returns

Ignores the timing of cash flows

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Net Present Value

It values future cash flows in terms of todays money

1. Present Value = cash inflow x discount rate

2. Net Presesnt Value = Present value -- Initial Investment

Advantages:

Can validly compare investments with significantly different amounts of start up capital

Takes into account the effects of inflation - external factors

Disadvanatges:

Very difficult to be accurate, especially in the long term

It doesn't compare expected returns with the cost of investment

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