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These three techniques all involve estimating the total cash outflow and cash inflows over the
investment
Investment appraisal: the process of analysing the financial mertis of a possible future
Investment Appraisal
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Investment is used in relation to capital expenditure. I,e the purchase of assets that wil stay in the
business in the medium to long term.
Managers do not take investment decisions lightly as there is no such thing as a risk free investment
and all investments have both financial and opportunity costs.
Similarly, when weighing up the financial merits of an investment, managers will have to focus
on the objective of maximising shareholder returns. A business with the objective of being market
leader is likely to have an ongoing investment in the most up to date machinery or extensive R&D
a threat to the short term survival of a firm.
but if it takes four years before a positive net cash flow is achieved then this might pose too great
It does not take into account the timing of cash inflows, an investment may seem very profitable
The higher the ARR, the more potentially profitable the investment.
Divide the average annual profit by the initial investment and express as a % Second
by a number of years
First Calculate average annual profits by adding up all the net cash flows divided
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Payback
Payback: calculation of how long it will take to recoup the cost of an investment.
Payback evaluates individual investment projects in terms of the time taken to recover the outlay
First Add up the net cash flow for the project until you have enough to cover the initial investment.
Second Calculate the amount still needed for machine A in the year of payback and divide by the net cash inflow for that
year and multiply by 12 to calculate the month of payback
The shorter the payback period, the less risk involved in the project and the quicker the business can start to generate
profit from its investment.
Payback is the most commonly used form of investment appraisal because of its simplicity.
Very important to businesses with potential cash flow problems. (Liquidity) or if the investment is in technical equipment
which is likely to become obsolete or out of date quickly. is important to highly geared firms.
It fails to take into account any inflows after payback and ignores the overall profitability of the project. assumes that in the
year of payback the cash inflow is steadily spread across the year.
be influenced by the culture of the organisation, whether one of risk taking or risk aversion.
The specific criteria set will depend upon the nature of the business and the investment. It will also
Investment Criteria
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Net Present Value: the total net return of an investment stated in todays monetary value
100 received today is more than 100 received in the future. If the 100 received today was invested in the bank, it would
grow in value each year. This is done by use of a discount factor
Discount factor: the rate by which future cash flows are reduced to reflect current interest rates
First Multiply each years net inflow by the relevant discount factor to calculate NPV
Second Add up all the NPVs to calculate the net cash gain from the project expressed in todays terms.
If the project has a positive NPV then it should be accepted. The higher the NPV the better. positive accept, negative
reject provides managers with a simple rule for decision making.
It doesnt account for the speed of repayment, can be difficult to choose the right discount factor and non financial managers
may find the concept hard to understand.
The overall time period of future projections.
The stability of the market and associated likely accuracy of sales forecasts
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The degree of risk associated with a project will be dependant on a number of factors. Key points
to consider will include:
# The impact of the investment on other aspects pf the business, for example day to day funding.