Lecture notes
Investment Appraisal
- Institution
- CCEA
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.
[Show more]
1 review
By: katiegeddis • 3 year ago
Content preview
Investment AppraisalDefinition:
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.
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller MarkC57. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for £3.49. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
73216 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy revision notes and other study material for 14 years now