Investment Appraisal Techniques

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Investment Appraisal

Investment: Spending money into something with an expectation of making profit/ increasing wealth in the future Investment Appraisal: Is a process of evaluating the attractiveness of an investment proposal using various techniques/methods,

Methods

Payback period
Accounting rate of return (ARR – ROCE)
Investment appraisal
Internal rate of return (IRR)

Pay Back Period (PBP)
The Payback Period (PBP) - The time taken by the project to repay the investment or

The time taken where, Cash inflows = Cash Outflows
* Usually expressed in years

It really considers the flow of cash into the business and outside the business

Decision Rule: A project is good if PBP is either equal or lower than the target period

But PBP is not adequate on its own as an investment appraisal technique. Example
Project PProject Q
$ $
Capital investment60,00060,000
Profits before depreciation (a rough approximation of cash flows) Year 120,00050,000
Year230,00020,000
Year340,000 5,000
Year450,000 5,000
Year560,000 5,000

Here,
PBP for P More than 2 year
PBP for Q Less than 2 year
So, on the basis of PBP project Q is preferred
However, if we look at the total returns of the project over the period of 5 years, Project P appears to be better as total return is $200,000 where as total return under project Q is $85,000. Conclusion: PBP on its own is not an adequate investment appraisal technique. Advantages:

* simple and easy to calculate and understand
* Uses cash flows rather than accounting profits
* It can be used as screening device as a first stage in eliminating obviously inappropriate projects prior to more detailed evaluation Disadvantages:
* It ignores timing of cash flows within the PBP
* It does not take into account of time value of money
* It is based on the estimation of future cash flows

ROCE/ARR (The return on capital employed or Accounting rate of return) * Also known as Return on Investment (ROI)
* Based in future potential accounting profit.

Formula,

ROCE/ARR = (Annual Return/ investment) x 100%

Decision Rule: If ROCE of a project is greater than target rate of return, accept the project

Example 1: The following information is related with an investment: Income during a year = £15,000
Total investment = £60,000

Then, ARR= (15,000/60,000) x 100%= 25%

Advantages/ Disadvantages
Advantages:
* Simple and easy to calculate and understand
* It considers entire project life

Disadvantages:
* Based in accounting profit and not cash flows. Accounting profits are subject to various accounting treatments. * It is a relative measure but not a absolute one
* Ignores time value of money

Things to remember:
1) Normally Working capital injected at the start will be repaid at the end of the project period 2) Residual value will be +ve cash flow at the end of the project period 3) +ve cash flows = not shown in brackets, but –ve cash flows= shown in brackets 4) Need to apply discount factor at the end to find discounted cash flow that gives value discounted to present time

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Advance methods Discounted cash flows – Investment appraisal methods

1. Compounding

Where the interest accrued is added back to the principal and interest is applied to the gross amount, this is known as compounding.

E.g. Company A invests $10,000 at an annual return of 10%, and then the value of the investment would build up as follows:

(a) After 1 year$10,000x (1.10)=$11,000
(b)After 2 years$11,000 x (1.10)= $12,100
(c) After 3 years$12,100 x (1.10)=$13,310 and so on.

Here,...
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