Investment Appraisal Unit 3.2. When considering a major purchase a firm will take into account: . The initial cost Future benefits e.g. revenues, residual value Future costs e.g. interest payments, depreciation Alternatives e.g. other projects and uses of funds
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Investment appraisal looks at how to answer the question 'is it worth investing in that project?'
Investment appraisal is a forward-looking process. It considers what might happen, and makes forecasts. These are then used to make calculations and analyses. However, these forecasts will always contain elements of inaccuracy, uncertainty and risk and we learn in these sections also how to take account of this.
Investment appraisal is built around estimates of future cash flows - cash flow into and out of the company as a result of a particular investment project.
Thus there is a considerable element of risk when these figures are used.
It is important when considering the results of investment appraisal operations to be aware of the source and the quality of the data involved. An allowance should be made for the risk element.
Initial investment cost Contribution per month
A newspaper considering the purchase of a new printing machine is faced with the choice between ‘The Printswell’ and ‘The Hotpress’ both initially costing £120,000
The Printswell = 3 years 122 days (since 20/60 x 365 = 122)
The Hotpress = 2 years 91 days (since 10/40 x 365 = 91)
easy to calculate
provides a useful measure of risk (Hotpress is a safer bet)
the shortest payback is useful where:
technology or consumer tastes change rapidly (helps to avoid assets becoming obsolete)
funds are limited - helps reduce indebtedness & cashflow problems
ignores timing of returns
ignores all net returns after the payback date
takes no account of the long-term profitability of a project
ARR = average return per year/ initial amt invested x 100
The Printswell = 16.7%
The Hotpress = 13.3%
takes account of returns over the whole life of a project
provides a comparison with the returns available on alternative uses of funds
ignores the timing of returns e.g. a project with high returns in the early years may be more preferable to one that is more profitable overall
Ignores the effect of inflation on the value of money over time
So, with all of the problems associated with these methods of analysis, what are they used for?