# Managerial Decisions- D

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?

Positives:

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

Negatives:

• 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

Positives:

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

Negatives:

• 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

Positives:

• 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

Positives:

• 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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