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INVESTMENT APPRAISAL, There are three methods of investment appraisal -…

- - - - Payback period is the simplest and quicker method of investment appraisal / commonly used method
      - It can be useful for firms with cash flow problems as they can identify how long it would take for the cash to be regain.
      - it will allows a firm to see whether it will break-even on the purchase of an asset before it needs to be replaced
      - The payback period can be used to compare different investment projects with different costs by calculating the quickest payback period of each option
      - It helps assess projects which will yield a quick return for shareholders
    - - Contribution per month is unlikely to be constant as demand is prone to seasonal fluctuations so the payback period might take longer
      - Payback period focuses on time as the key criterion for investment , rather than on profits - the main aim of most private sector businesses
      - It can encourage a short-termism approach to investment
        For example : Managers only focus on the short-term benefits and ignore the potential gains in the longer term
      - Payback period might not be highly suitable for some firms
        For example : property developers and airline manufacturers are unlikely to regain their investments for many years.
      - Calculations are prone to errors as it is difficult to accurately predict future cash flows.
- - - - For example : if the ARR of a project for a large established multinational such as McDonald's is 7% whilst the interest rate on savings is 3%, the real rate of return is 4%
  - - - Flexible time frame. The rate of return method can cover any time period that an investor specifies.Each investor has his own time horizon, which refers to how soon the investor may want to sell the investment. Investors with long time horizons, such as young workers beginning to save for retirement, can use decades of data to determine average rates of return for various investments. An investor with a shorter time horizon can use more recent data to create a short-term average rate of return.
      - Eliminates outlying statistics. it relies on averages, the average rate of return method eliminates outlying statistics in sets of data. This is especially useful in long-term averages, where many years of gains can minimize the impact of a single year of losses.
      - Simple comparison . The average rate of return method allows for a simple comparison between different types of investments. Since it results in a single percentage, investors can an investment's returns if produces its average rate of return in the future.
    - - Does not take into account the time value of money. This is the concept that money is worth a known amount today, but there is no certainty what the same amount of money will be worth in the future. In other words, you know what you can buy today with a given amount of money. You do not know what you can buy for the same amount of money tomorrow, and the longer it takes you to earn back your investment, the greater the risk involved with sustaining the purchasing power of that future money value.
      - This technique is based on profits rather than cash flow. Therefore it can be affected by non-cash items such as the depreciation and bad debts when calculating profits. The change of methods for depreciation can be manipulated and lead to higher profits.