Managerial Decisions- D


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Investment Appraisal Methods

e.g. firm must decide between two efficiency systems 

  • Payback Method
  • Accounting Rate of Return (ARR)
  • Net Present Value (NPV)
  • Profitability Index
  • Internal Rate of Return (IRR)
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Payback Method

Which Project repays Initial Capital Cost quicker?


  • simple/easily understood
  • quick payback may be essential
  • investors usually demand fast returns


  • lack of objectivity
  • cannot estimate future profitability of company
  • post payback cash flows are ignored
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Accounting Rate of Return (ARR)

Where the Profit Generated is compared to the Cost of Investment

= (Average Annual Profit/Average investment) x 100


  • simple
  • allows for differences in the projects
  • good to manage managerial performance


  • project duration and timing of cash flows are ignored
  • concept of profit is subjective, depending on accounting practice
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Net Present Value (NPV)

PV = FV/(1+(0.01*r))^n

Compares investment options by valuing cash payments and cash reciepts expected to be earnt.

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Profitability Index

(PV of future cash flow) / (PV of Initial Investment)

at PI=1, company breakseven

therefore, accept project if PI > 1


  • allows comparision of costs/benefits
  • determines how scarce funds can be allocated
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Internal Rate of Return (IRR)

rate of interest that makes NPV = 0


  • measures worth/risk of project
  • allows comparison of projects
  • software/simple graphs allows the IRR to be found
  • allows cash flows to be evaluated at different discount rates

Can be found by trial and error using different rates of interest until NPV =0

If IRR > opportunity cost of capital                                                                         the project is profitable and will yield a positive NPV

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Incorporating Risk/Uncertainty in Investment Appra

  • Collect Data/Estimates on probability of different values of cash flow
  • Run a Monte Carlo Simulation of cash flows
  • Use results to estimate the probabilities and values of key statistics including min, max and expected
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