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Investment Decision Making
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A look at investment decision making including payback with its advantages and disadvantages.
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Investment Decision MakingDefinition:
How a business decides - capital investment project e.g. new machinery or factory.
Is it worthwhile.
Uses financial techniques but also take account - qualitative factors.
Basis of the Decision: Methods of Appraisal:
Initial cost. Payback.
Net return. Average Rate of Return
Lifetime. (ARR).
Payback: Net Present Value (NPV).
Number of years - recover the cost.
𝑨𝒎𝒐𝒖𝒏𝒕 𝑶𝒖𝒕𝒔𝒕𝒂𝒏𝒅𝒊𝒏𝒈
𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒇𝒖𝒍𝒍 𝒚𝒆𝒂𝒓𝒔 + 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 𝑵𝒆𝒙𝒕 𝒀𝒆𝒂𝒓
Year Cash Outflow Cash Inflow Year Cash Outflow Cash Inflow
1 500,000 100,000 1 500,000 100,000
2 200,000 Payback is
2 100,000
3 200,000 achieved at year 3 200,000
4 150,000 3 + 4 months. 4 300,000
Payback is
achieved at end
of year 3.
Evaluating Payback:
Advantages Disadvantages
Quick + simple. Ignores money received after payback.
Useful to a firm - recuperate cost quickly as possible - Adequate resources - take risk of waiting to gain
limited funds/liquidity problems. bigger rewards.
Estimates = more accurate in ST than LT. Cash flow estimates.
Compare with ARR + NPV. Doesn't take into account - time value of money
unlike NPV - discount factor present value.
Force short termism - focus on liquidity + not profit.
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