Investment appraisal

http://www.thestudentroom.co.uk/wiki/revision:investment_appraisal

PAYBACK
Works out how long it takes to repay the initial investment. e.g. Investment A. costs 100. Annual return of 25 Length 5 years YEAR 0 1 2 3 4 5 NET CASH FLOW CUMULATIVE CASH FLOW (ANNUAL RETURN) (CASH IN FLOW) -100 -100 25 -75 25 -50 25 -25 25 0 25 25

Payback is 4 years.

Sometimes it is necessary to calculate the month of payback when the figure is reached part way through the year. To do this you would you use formula:

ADVANTAGES

Easy to calculate Easy to understand Most relevant to businesses with cashflow problems Emphasises speed of return good in rapidly changing markets

DISADVANTAGES

Ignores money received after payback Can be difficult to establish a target payback period Doesnt consider the future value of money Short term approach

AVERAGE RATE OF RETURN

Compares profit with money invested.

To work this out, break it down into stages.

Calculate lifetime profit = total inflows outflow Divide by the number of years Use the formula

e.g. Investment A cost 100 25 return for 5 years

1. Inflow outflow 125 - 100 = 25

2. Divide by the number of years. 25/5 = 5

3. Use formula 5 / 100 X 100 = 5% return

ADVANTAGES

Percentage provides easy comparisons across projects Shows the profitability of a project

DISADVANTAGES

Harder and more time consuming Ignores time value of money

NET PRESENT VALUE (DISCOUNTED CASH FLOW)

This takes into account the time value of money. It is based on the principle that money is worth more than it is in the future. The principle exists for two reasons:

Risk money in the future is uncertain Opportunity cost Money could be in an interest account earning interest.

Discounting
This is the process of adjusting the value of money from its present value to its value in the future. The key to discounting is the rate of interest. The business chooses the most appropriate rate for the life of the project. It then identifies the discounting factor. The amount of money is then multiplied by the discounting factors to convert it to its net present value.

e.g. Project A 100 25 return 5 years

YEAR NET RETURN DISCOUNT FACTOR NET PRESENT VALUE 0 -100 0 -100 1 25 0.952 23.8 2 25 0.907 22.675 3 25 0.864 21.6 4 25 0.823 20.575 5 25 0.784 19.6 = 108.25

108.25 MINUS INITIAL COST (100) = 8.25 Profit = 8.25

ADVANTAGES

Considers the time value of money Reducing discounting rate reduces future monies more heavily Only one method that gives a definitive answer Positive return it is worth doing

DISADVANTAGES

Time consuming More difficult to understand Based on an arbitrary choice of interest rate