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AL Chapter 19 - Investment appraisal - Coggle Diagram
AL Chapter 19 - Investment appraisal
Concept of investment appraisal
Need for investment appraisal
Involve large sums of money
Involve making decisions that are difficult to reverse
Investment decision are made, the business can only estimate the costs and revenues
A sudden economic downturn or change in other external factors can change all predictions
Occurs when a business assesses are likely returns from undertaking a course of action, such as purchasing premises...
Businesses need to know the potential financial returns on any project they are considering
Basic methods of investment appraisal
Payback method
Method calculated the time it will take for the net cash inflows to completely cover initial investment
The time of the initital investment is termed Year 0, each year the cash outflows and inflows are added to give the net cash inflow.
The net cash inflow is deducted from cost of initial investment to give a 'cumulative cash flow' for year 1
Payback period = Amount still to be recovered / Net cash flow in the following year
Accounting rate of return
The ARR method of investment appraisal calculates the expected profit per year as a percentage of cost of the original investment over the anticipated lifetime of the project
ARR = Average annual profit / Initial cost of investment X 100
Would be compared to the return that could be gained if they money was used in a different way
Comparison of investment appraisal methods
Payback method measures time, ARR method measures rate of return
They are both easy and quick to calculate
Payback method focuses on when the returns come in, ARR doesn't take that into account
Discounted cash flow methods
Payback and ARR assume that money received in the future has they same value as money today
Discounted payback recognises that money received in 3 or 4 years time will not have the same value in our possession today
In investment appraisal, we can use a discounting factor to allow us to judge the value of money in the future, compared to value today
Discounted payback
Take each net cash flow and X by discounted factor which gives you the discounted net cash flow
Present value
Amount that would have to be invested toady at the given discounted rate to become the same sum as the expected inflow in the future
Net present value
NPV is an investment appraisal method, that uses the discounted value of net cash flows, taking account of the initial costs of investment
NPV = Sum of all present values of future expected returns - initial costs
If the number is positive, the returns exceed the cost to day and the investment should go up
Qualitative factors in investment appraisal
The investment appraisal methods are all quantitative methods
Pollution - if a project was to pollute the environment, it shouldn't be pursued
Employment levels - Social considerations are sometimes judged as important
Quality - Is the quality going to be the same, will this affect brand image