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FINANCIAL METHODS OF ASSESSING INVESTMENT

Investment Appraisal Overview

Core Purpose

Investment appraisal evaluates the feasibility and profitability of capital projects. We analyze different methods to determine which project creates the most value.

Method 1: Payback Period

Definition

This is the Time taken for the investment to generate enough cash flow to recover the initial outlay. It prioritizes liquidity and speed of return.

Payback Period Calculation

Payback Period = Years before full recovery + (Unrecovered cost at start of year / Cash flow during year)
The simplest measure focusing purely on cash recovery time.

Payback Pros vs. Cons

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AdvantageSimple and easy to understand. Useful for firms prioritizing liquidity.
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DisadvantageIgnores cash flows after payback and time value of money.

Method 2: Average Rate of Return (ARR)

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ARR

Measures average annual profit from investment as a percentage of initial cost.
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Comparison

Considers total profit and is useful for comparing projects.

ARR Calculation

ARR = (Average annual profit / Initial investment) x 100
This method uses accounting profits rather than cash flows.

Method 3: Net Present Value (NPV)

NPV = Sum of (Cash inflow / (1 + r)^t) - Initial Investment
r = discount rate (cost of capital), t = time period. This is the preferred method for value creation.

NPV Decision Rule

Key Takeaway

Calculates present value of all future cash flows discounted at a set cost of capital, subtracting initial investment. Positive NPV indicates value creation.

Factors Influencing Investment

1

Investment Criteria

Minimum acceptable criteria set by the firm, such as a minimum ARR or maximum payback period.
2

Non-Financial Factors

Strategic fit, brand impact, CSR considerations, technological advancement, and regulatory compliance.

Dealing with Risk

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How do we account for uncertain future returns in our calculations?
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Investments involve future cash flows that are uncertain. Risk assessments (e.g., sensitivity analysis) help gauge how changes impact returns.

Final Investment Decision

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External Environment: Economic conditions, political stability, competition may influence viability. The choice to invest requires balancing these factors with expected financial returns.

Financial Methods of Assessing Investment
Term
Payback Period

What does the Payback Period measure?

Answer
Definition

The time taken for an investment to recover its initial cost through cash flows.

Term
Calculating Payback Period

How do you calculate the Payback Period?

Answer
Formula

Years before full recovery + (Unrecovered cost at start of year รท Cash flow during year).

Term
Advantage of Payback Period

Name one advantage of the Payback Period method.

Answer
Advantage

It is simple and easy to understand.

Term
Disadvantage of Payback Period

What is a major disadvantage of the Payback Period?

Answer
Disadvantage

It ignores cash flows after payback and does not consider the time value of money.

Term
Average Rate of Return (ARR)

What does the Average Rate of Return (ARR) indicate?

Answer
Definition

The average annual profit as a percentage of the initial investment cost.

Term
Calculating ARR

How is ARR calculated?

Answer
Formula

(Average annual profit รท Initial investment) ร— 100%.

Term
Limitation of ARR

What is a limitation of ARR?

Answer
Limitation

It ignores the timing of returns and associated risks.

Term
Net Present Value (NPV)

What key factor does Net Present Value (NPV) consider that others don't?

Answer
Key Factor

The time value of money by discounting future cash flows.

Term
Calculating NPV

How is NPV calculated?

Answer
Formula

NPV = ฮฃ (Cash inflow รท (1 + r)^t) - Initial Investment, where r = discount rate and t = time period.

Term
Positive NPV

What does a positive NPV indicate?

Answer
Meaning

The investment is expected to create value and be profitable.

Term
Financial Factor

List one financial factor that influences investment decisions.

Answer
Example

Investment criteria such as a minimum acceptable ARR or maximum payback period.

Term
Non-Financial Factor

Name a non-financial factor affecting investment decisions.

Answer
Example

Strategic fit, brand impact, CSR, technological advancement, or regulatory compliance.

Term
Importance of Risk Assessment

Why is risk assessment important in investment decisions?

Answer
Reason

Because future cash flows are uncertain, risk assessment helps evaluate potential variability in returns.

Term
External Environment

How can external environment affect investment decisions?

Answer
Factors

Economic conditions, political stability, and competition can influence project viability.

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๐ŸŒธ Financial Methods of Assessing Investment Quiz

1. What does the payback period not consider?

The payback period ignores any cash flows that occur after the initial investment is recovered.

2. How is the Average Rate of Return (ARR) expressed?

ARR shows the average annual profit as a percentage of the initial amount invested.

3. Which financial method accounts for the time value of money?

NPV discounts future cash flows to their present value, considering the time value of money.

4. What does a positive NPV indicate?

A positive NPV means the investment is expected to generate profit above the cost of capital.

5. Which of the following is NOT a non-financial factor influencing investment decisions?

Minimum payback period is a financial criterion, not a non-financial factor.

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