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3.8 INVESTMENT APPRAISAL - Coggle Diagram
3.8 INVESTMENT APPRAISAL
investment appraisal
Evaluation of investments using quantitative techniques (looking for potential net gains)
Capital investment is based on 3 factors
Firm’s objectives
opportunities
constraints
qualitative issues that can be faced in making an investment
Objectives of the firm
External costs and benefits
Current or expected state of the economy
Past experiences
Corporate image
-Whether the investment will conflict with a company’s values
Exogenous shocks
Unexpected economical change (e.g. fall in stock prices, rise in prices of housing, etc.)
cash flows
Estimated profits over the lifetime of the investment
Cumulative cash flow
Cash flow based on total cash is subtracted by total cash out for a specific duration of time
Cumulative cash flow = Total cash out – Net cash flow up to that period
methods of investment appraisal
Average rate of return (ARR)
Expressed as % to allow comparisons between investment projects with different initial outlays
Calculates the average profit of an investment as a % of the investment
computation
ARR = (Average annual profit / Initial outlay) * 100
(Total cumulative cash flow – initial outlay) / No. of years of investment’s life span
advantage
Enables easy comparisons of the returns of different projects
disadvantage
Ignores timing of cash inflows (e.g. seasonal factors)
Project’s lifespan is needed, which might just be a random guess
Errors are likelier the longer the forecasting period
Payback period (PBP)
Time it takes for an investment to repay the initial outlay
Calculation is based on cash flows
Short term, works with the nearest month
Calculate month of payback = (Income required / Contribution per month)
Contribution per month = (Cash flow for next year / 12)
Important notes
Projects with long payback will be disregarded but payback will rarely be used by itself to make an investment decision
How much of a deterrent is high risk?
disadvantage
Encourages short-term approach to investment
Contribution per month is likely to be constant
Focuses on time as the key criterion rather than profit
Lacks qualitative assessment
advantage
Simple and quick
Firms can identify how long they can recoup and whether or not it will break-even on a purchased asset
Compare different investment projects
Assess projects that yields quick returns
Short term, so calculations are less prone to forecasting errors