A look at investment appraisal including working examples of payback, avergae rate of return (ARR) and Net Present Value (NPV).
Advantages and disadvantages of each method is provided.
Is how a business decides if a capital investment project e.g. new machinery or new factory is worthwhile.
Uses financial techniques, but firms should also take account of non-financial (qualitative) factors.
Decision based on: Methods of Appraisal:
Initial cost. Payback.
Net return. Average rate of return (ARR).
Lifetime.
Net Present Value (NPV).
Payback:
Finds out the number of years it takes to recover the cost.
Year Cash Outflow Cash inflow Payback is Year Cash Outflow Cash Inflow
1 500,000 100,000 Payback = 3
achieved end 1 500,000 100,000
2 200,000 years + 4
of year 3. 2 100,000
3 200,000 months.
3 200,000
4 150,000
4 300,000
Payback Evaluation:
Advantages Disadvantages
Quick + simple. Ignores money received after payback – machine B = longer payback but
financially more attractive.
Useful to a firm – recuperate as quickly as possible due Adequate resources may be able – take risk and wait for bigger rewards.
to limited funds + possible liquidity problems.
Estimates more accurate in ST than LT. Cash flow estimates – inaccuracies + these don’t take account of – time
value of money e.g. costs and revenues.
Compare with ARR + NPV. Could force short termism focusing on liquidity not profitability.
Average Rate of Return (ARR):
Method of investment appraisal - measures the net return per annum as a percentage of initial spending.
Three key stages:
Calculate the overall profit: Sum of profits each year - initial costs:
Machine A = £16,000 - £10,000 = £6000.
Machine B = £19,000 - £10,000 = £9000.
Calculate the average annual profit: Above divided by number of years:
Machine A: £6000/5 = £1200.
Machine B: £9000/5 = £1800.
Average profit as a %:
Machine A: £1200/£10,000 = 12% ARR.
Machine B: £1800/10,000 = 18% ARR.
Advantages Disadvantages
Compares profitability - firms - maximise profits see Ignores time value of money.
clearly best option.
Expressed as a % - easy to compare - save time +
reduce risk factor + easy to communicate to the staff.
Easy to compare alternatives e.g. ARR - 10% Uses cash flow estimates.
compared with other financial institutions e.g. high Can't compare an ARR on a machine with that of a
interest bank or share. bank/building society.
Uses all the figures unlike payback. LT - more inaccuracies so payback = more accurate on
this front.
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