3.8 INVESTMENT APPRAISAL
The process of analyzing whether investment projects are worthwhile (profitability & desirability)
PAYBACK METHOD
AVERAGE RATE OF RETURN, ARR
QUANTITATIVE INVESTMENT APPRAISAL
Method:
payback method
average rate of return
net present value using discounted cash flows
Requires informations:
initial capital-cost of the investment
life expectancy
residual value of the investment
forecasted net returns or net cash flows from the project
The time it takes for a project to repay its initial investment
Calculation
Evaluation
1) identify the net cash flows for each period (e.g year)
2) keep a running total of the cash flows
initial investment = an outflow
when does the running total move from negative (outflow) to positive (inflow) ?
when the total net cash flow becomes positive, that is the end of the payback period
benefits
drawbacks
simple and easy to calculate
easy to understand the results
focuses on cash flows
emphasises speed of return: good for markets which change rapidly
straightforward to compare competing projects
ignores cash flows after payback has been reached
takes no account of the "time value of money"
may encourage short-term thinking
ignores qualitative aspects of a decision
does not actually create a decision for the investment
formula to calculate the precise payback
payback period = years before full recovery + [(unrecovered cost at start of the year)/(cash flow during the yaer)]
measures the annual profitability of an investment as a percentage of the initial investment
calculations
evaluations
benefits
drawbacks
1) add up all positive cash flows
2) subtract cost of investment
3) divide by lifespan
4) calculate the annual profit as a percentage of the initial cost
formula
ARR (%) = [(ANNUAL PROFIT, net cash flow) / (INITIAL CAPITAL COST)] X 100
Uses all the cash flows
focuses on profitability
easy to calculate and simple to understand
the results can be quickly assessed against the predetermined criterion rate of the business
ignores the timing of the cash flows
does not consider terminal value of the project
ignores the time value of the money