Investment appraisal
nature of investment decisions
large amounts of resources are often involved
It is often difficult and/or expensive to bail out of an investment once undertaken
Accounting rate of return(ARR) decision rule
For a project to be acceptable,it must achieve a target ARR as a minimum
Where two(or more)competing projects exceed the minimum rate,the one with the higher(or highest) ARR should be selected
Payback period
is the length of time it takes for an initial investment to be repaid out of the net cash inflows from a project
PP decision rule
for a project to be acceptable,
it should have a shorter payback period
than the maximum payback period set by the business
I two (or more)competing projects have paybak periods shorter than the maximum payback period,
the project with the shorter(shortest)payback period should be selected
Net present value
present value of cash inflows are compared to the PV of cash outflows,
the difference is the Net Present Value
recognises the Time Value of Money
NPV decision rule
If the NPV of a project is positive,
it should be accepted;
If it is negative it should be rejected
If two(or more)competing projects have positive NPVs,
the project with the higher(or highest) NPV should be selected
Why NPV is superior to ARR & PP
timing of the cash flows
The whole of the relevant cash flows
The objectives of the business
Internal rate of return(IRR)
definition
The internal rate of return is the discount rate,which,when applied to the future cash flows of a project,will produce an NPV of precisely zero
IRR decision rule
For a project to be acceptable,
It must meet a minimum IRR requirement(This should be the opportunity cost of finance.)
If two(or more)competing projects exceed the minimum IRR,
the one with the higher(or highest) IRR should be selected
Investment appraisal in practice
Businesses tend to use more than one method
NPV and IRR have become increasingly popular
Continued popularity of the PP and ARR methods
Larger businesses rely more heavily on NPV and IRR than smaller businesses do