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3.3.2 Investment appraisal - Coggle Diagram
3.3.2 Investment appraisal
Investment appraisal
the process of using forecast cash flows to assess the financial attractiveness of an investment decision, linked with a consideration of non-financial factors
can be linked to cash flow forecasting + sales forecasting techniques
The choice of which method is used can depend on wether a company is taking a long term or short term view on investments (links to 3.4)
Payback period
Assesses the amount of time a business has to wait until they have recovered from the initial investment spent. This allows a firm to prioritise risk reduction when making investment decisions.
= (outlay outstanding/cash flow in year of payback) x 12
The answer is written " Year before cash flow payback occurs, month payback occurs"
Interpretation
calculates the length of time the investment is 'at risk'
once payback has occurred, the firm is now not losing any money from the investment - so the quicker the better
In the long term, the project may not be seen as profitable, so its best to use other investment appraisal techniques to confirm the profitability/suitability of an investment's return
Strengths of this model
easy to calculate and understand
may be more accurate as it ignores long term forecasts which may be less accurate (extrapolation)
takes into account timing of cash flows
useful for businesses with weak cash flow
Limitations of this model
tells us nothing about profitability
ignores what happens after payback
may encourage short-termist attitude
Average Rate of Return (ARR)
Considers the profit generated by an investment. Involves calculating the average annual profit as a percentage of the initial investment
To calculate
Calculate total profit over the lifetime of the project by (-initial investment) + (all the added net cash flow)
Divide by number of years the project has lasted
Apply formula: (average annual profit (this value comes from step 2)/initial investment) x 100
Can be compared to firm's ROCE - a project that has lower ARR than current ROCE generated by the whole business is unlikely to be attractive - it would reduce the overall ROCE if the business accepted
Strengths of this method
clear focus on profitability
considers cash flows over whole project's time
easy to compare with measures of return expressed as percentages such as interest rates
Limitations of this method
ignores timing of cash flows
values far distant inflows as much as more immediate inflows, which are worth more
Including forecast data from far in the future may reduce reliability of forecasts and results
Net Present Value (NPV)
future cash flow may not be worth what they seem
To calculate
Multiply relevant discount factor to net cash flow for each year = present value
add up all the present value = NPV
Interpretation
Positive NPV - project generates higher return on its initial investment, higher the figure the better
Strengths of this method
takes opportunity cost into consideration
one calculation that considers both amount and timing of cash flows to indicate profitability
Limitations of this method
Complex to calculate and communicate
meaning is often misunderstood
only comparable between different projects if the initial investment is the same