A21 Business Studies (Investment Appraisal) Measuring the potential success of capital investment projects

Reasons for Investment Appraisal Can give advice to managers and help them make decisions on capital investment projects Enables projects to be evaluated Can compare competing projects Decisions are based on financial criteria

Problems of Forecasting Cash Flow The validity of future cash flow figures Interpretation of the figures Does not consider all aspects of the business May not consider business objectives

Investment Appraisal Payback Average rate of return Net present value

Payback The time it takes for an investment to repay the initial outlay Month of payback = Income required Contribution per month

Payback Advantages Limitations Works out how fast the cost of the investment can be paid back Advantages Limitations Easy to understand Simple to use Good for screening projects Indicates how long money is at risk Does not take into account any cash flow after the payback period Overall profitability of the investment is not considered Does not consider the current value of the cash

= Average annual return *100 Average Rate of Return Compares the average annual profit generated by an investment with the amount of money invested in it ARR = Average annual return *100 Initial outlay

Average Rate of Return Advantages Limitations Takes into account all cash flows throughout the life of the investment Gives an idea of cash flow and profitability Does not consider when cash flows occur Does not consider the value of the cash flows over time

Net Present Value Payback and ARR assume that the timing of future cash flows is unimportant. Net Present Value (NPV) takes into consideration the time value of money. Future sums are discounted or reduced by a certain percentage (say 5%, 10% etc) to reflect their lower value. Also known as Discounted Cash Flow (DCF).

Net Present Value Advantages Limitations More realistic – considers the time value of money Can consider various scenarios Complex to calculate Results are easy to misread Discount rate used is critical

A21 Business Studies (Investment Appraisal) Factors Influencing Investment Decisions Management objectives Capital available Returns on net assets Opportunity cost Technology used Length of investment Risk Qualitative /Quantitative