3.8. Investment Appraisal

  • Investment appraisal
    • Evaluation of investments using quantitative techniques (looking for potential net gains)
    • Capital investment is based on 3 factors
    • Firm’s objectives
      • Opportunities
      • Constraints
  • Qualitative issues that can be faced in making an investment
    • Objectives of the firm
    • External costs and benefits
    • Current or expected state of the economy
    • Past experiences
    • Corporate image
      • Whether the investment will conflict with a company’s values
    • Exogenous shocks
      • Unexpected economical change (e.g. fall in stock prices, rise in prices of housing, etc.)
  • Cash flows
    • Estimated profits over the lifetime of the investment
    • Cumulative cash flow
      • Cash flow based on total cash is subtracted by total cash out for a specific duration of time
      • Cumulative cash flow = Total cash out – Net cash flow up to that period
  • Methods of investment appraisal
    • Payback period (PBP)
      • Time it takes for an investment to repay the initial outlay
        • Calculation is based on cash flows
        • Short term, works with the nearest month
        • Calculate month of payback = (Income required / Contribution per month)
        • Contribution per month = (Cash flow for next year / 12)
        • Important notes
          • Projects with long payback will be disregarded but payback will rarely be used by itself to make an investment decision
          • How much of a deterrent is high risk?
        • Advantage
          • Simple and quick
          • Firms can identify how long they can recoup and whether or not it will break-even on a purchased asset
          • Compare different investment projects
          • Assess projects that yields quick returns
          • Short term, so calculations are less prone to forecasting errors
        • Disadvantages
          • Encourages short-term approach to investment
          • Contribution per month is likely to be constant
          • Focuses on time as the key criterion rather than profit
          • Lacks qualitative assessment
    • Average rate of return (ARR)
      • Calculates the average profit of an investment as a % of the investment
      • Expressed as % to allow comparisons between investment projects with different initial outlays
      • Computation
        • Calculate profit over lifetime of investment
          • (Total cumulative cash flow – initial outlay) / No. of years of investment’s life span
          • ARR = (Average annual profit / Initial outlay) * 100
          • Advantages
            • Enables easy comparisons of the returns of different projects
            • Disadvantages
              • Ignores timing of cash inflows (e.g. seasonal factors)
              • Project’s lifespan is needed, which might just be a random guess
              • Errors are likelier the longer the forecasting period
  • Net present value (HL only)
    • Calculates sum of all future expected net cash flows
    • Used to find out the value of future profits today (as money received in the future is worth less than if received today due to inflation)
    • Process
      • Calculate annual net cash flows of the project
      • Select appropriate rate of interest or required rate of return
      • Obtain the discount factor
      • Multiply net cash flow by discount factors
      • Add present net values for each of the net cash flows
      • Compare total net present value with initial outlay

Kim De Leon3.8. Investment Appraisal

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