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Key Facts For Investment Appraisal
How to evaluate Payback, NPV and ARR
Date : 25/10/2021
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Uploaded by : Christina
Uploaded on : 25/10/2021
Subject : Business Studies
Investment Appraisal the key facts Payback Payback is the simplest method of investment appraisal. The payback period is the time it takes for a project to repay its initial investment. Payback is used measured in terms of years and months, though any period could be used depending on the life of the project (e.g. weeks, months). Payback focuses on cash flows and looks at the cumulative cash flow of the investment up to the point at which the original investment has been recouped from the investment cash flows. Advantages of Payback Simple and easy to calculate + easy to understand the results Focuses on cash flows good for use by businesses where cash is a scarce resource Emphasises speed of return may be appropriate for businesses subject to significant market change Straight forward way to compare competing projects Disadvantages of Payback Ignores cash flows which arise after the payback has been reached i.e. does not look at the overall project return Takes no account of the time value of money May encourage short-term thinking It assumes that all cash flows arise equally every month (may not, especially for a seasonal business) Does not actually create a decision for the investment Net Present Value - NPV Net present value ("NPV") uses an important concept in investment appraisal discounted cash flows. NPV recognises that there is a difference in the value of money over time This is the opportunity cost of money and also called the time value of money A positive NPV for a project suggests that the investment project should go ahead A negative NPV would suggest that a project should be rejected If choosing between 2 or more projects, choose the project with the highest NPV Advantages of NPV Takes account of time value of money, placing emphasis on earlier cash flows Looks at all the cash flows during the whole the life of the project Use of discounting reduces the impact of long-term, less certain cash flows Has a decision-making mechanism reject projects with negative NPV Maybe most helpful for projects with very long lives Disadvantages of NPV More complicated method users may find it difficult to understand Difficult to select the most appropriate discount rate may lead to good projects being rejected The NPV calculation is very sensitive to the initial investment cost Accounting Rate of Return ARR Business investment projects need to earn a satisfactory rate of return if they are to justify their allocation of scarce capital. The ARR looks at the total accounting return for a project to see if it meets the target return (often referred to as a "hurdle rate"). Rather similar to ROCE. ARR = Average profit per year / cost of investment X 100 ARR uses PROFITS rather than cash flows So, if a question gives you NET CASH FLOWS: add up all the net cashflows deduct the cost of the investment by the number of years (or other time periods) The resulting figure then approximates AVERAGE PROFIT per year (i.e. in the accounts the investment would have been depreciated over the life of the investment) A key question will be - How does this return compare with the target return for other investments in this business? If it s much lower, it should be rejected as it may reduce the overall return of the business Advantages of ARR ARR provides a percentage return which can be compared with a target return ARR looks at the profitability over the whole life of the project Focuses on profitability a key issue for shareholders Disadvantages of ARR Does not take into account cash flows only profits (they may not be the same thing) Takes no account of the time value of money Treats profits arising late in the project in the same way as those which might arise early Tips when deciding which technique to recommend in exam Qs Think about who the interested stakeholders are: Payback NPV both use cashflow rather than profit so more useful for start ups or a business with cashflow issues or liquidity problems. Will a bank (loan) or shareholders (share capital) make the cash available if the business already has cashflow issues? ARR is the only one to use profit so this is the best to use if the business is trying to convince shareholders or new investors that this project is worth the investment. Think about the qualitative factors as none of the techniques take these into account: Examples of Non-financial Factors (Qualitative Factors): Corporate image Corporate aims and objectives Environmental and ethical issues Industrial relations e.g. technology means employees may be made redundant Distance from customers for deliveries Availability of finance Think about whether the long-term position is important: Only NPV and ARR consider returns over the whole life of the project Think about the cashflow situation: If cash/finance is a problem, say for a start up, speed of pay back may be the most important issue Think about the uncertainty of predicting future cash flows profits: Only NPV takes into consideration the time value of money by using the discount factor, so that cash flows in the future are worth less than today Sensitivity Analysis: A technique that uses variations in forecasts to allow for a range of outcomes A disadvantage is that it can only consider one variable at a time Ties in well to Decision Trees, Critical Path Analysis and Break Even as well However, still only as useful as the accuracy of the information available and how well the potential results are analysed and how well the plan is implemented Is the finance available? Benchmarking: A business can measure its performance against the established industry standards or against another similar successful business in the same sector Risk Uncertainty: Risk = the chance something bad or unexpected will happenExamples of why forecasts maybe inaccurate: Timescales New markets Competitor s reactions Costs rise e.g. £ fell after Brexit so import costs rose
This resource was uploaded by: Christina