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3.8: Investment Appraisal (Quantitative Investment Appraisal (Payback…
3.8: Investment Appraisal
What Is Investment Appraisal?
investment
: purchasing capital goods & improving existing fixed assets
investment appraisal
: evaluating the profitability or desirability of an investment project
undertaken by using quantitative techniques
non-financial issues are also significant, and therefore qualitative appraisal
there is also ‘intuitive’ or ‘hunch’ methods of taking investment decisions
Quantitative Investment Appraisal
information required:
initial capital cost of investment (with installation cost)
estimated life expectancy
residual value of the investment
forecasted net returns or net cash flows from the project
Payback Period
payback period
: length of time it takes for the net cash inflows to pay back the original capital cost of the investment
can be compared with the payback on alternative investments
‘year 0’ = time period in which the investment is made
cash flow at this time is negative
becomes less and less negative as further cash inflows are received
(additional cash inflow needed / annual cash flow in year X) * 12 months
used as a quick check on the viability of a project or as a means of comparing projects
Average Rate of Return
AAR = [annual profit (net cash flow) / initial capital cost] * 100
average rate of return (ARR)
: measures the annual profitability of an investment as a percentage of the initial investment
assume that the net cash flows = annual profitability
:four: stages
add all positive cash flows
subtract cost of investment
divide by lifespan
calculate the annual profit as % of the initial cost
can be compared with:
other proyects
citerion rate
: minimum level (maximum for payback period) set by management for investment appraisal results for a project to be accepted
the annual interest rate on loans
Discounting Future Cash Flows
when the other methods give conflicting results
solves problem of trying to compare projects with different returns and payback periods
considers both the size of cash flows and the timing of them
takes the ‘time value of money’ into consideration
discounting
: the process of reducing the value of future cash flows to give them their value in today’s terms
depends on the rate of interest
:two: factors
The higher the interest rate, the less value future cash has in today’s money.
The longer into the future cash is received, the less value it has today.
multiply the appropriate discount factor by the cash flow
Forecasting Cash Flows in Uncertain Environment
annual forecasted net cash flow
: forecasted cash inflow minus forecasted cash outflows
assume that cash inflows = annual revenues earned from the project & the cash outflows = annual operating costs
not easy & rarely 100% accurate
external factors can affect long term cash flow forecasts
all investment decisions involve some risk due to uncertainty
Net Present Value (NPV)
uses discounted cash flows
total discounted cash flows - capital cost of the investment
:three: stages
Multiply discount factors by the cash flows (cash flows in year 0 are never discounted)
Add the discounted cash flows
Subtract the capital cost to give the NPV
net present value
: today’s value of the estimated cash flows resulting from an investment
Qualitative Investment Appraisal
the impact on the environment and the local community
planning permission
aims and objectives of the business
risk
Cecilia Martínez A01197738
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