Finance

2.9 Investment appraisal

They are tools used by companies to decide where to invest and where their money can provide better returns

Payback period tool

  • The estimated time it would take for a business to make its money back from its initial investment
  • See how many years it takes for accumulated net flow to reach 0
  • Must divide the year in fractions if payback period is in the middle of a year
  • Formula:
Payback Period Formula

Advantage

  • Simple method; easy to calculate and understand
  • Useful in cases where businesses need to calculate when to buy a replacement
  • Useful for cash flow problems

Disadvantage

  • Provides no insight into profitability of investment
  • It is all a forecast; can mislead businesses if not calculated correctly
  • Doesn't consider the size of the investment; hard to compare them with each other

Example:

A project has an estimated cost of 2 million USD and is expected to result in an yearly net cash flow of 500000 USD. The payback period is 4 years: the amount of time it will take for the cumulative cash flow of the project to reach 0.

Payback Period Formula

Average rate of return (ARR)

  • Calculates the average annual profit of an investment expressed as a percentage of the initial amount of money invested in it
  • Formula:
ARR Formula

Advantages

  • Easy to calculate and understand
  • It focuses on profits rather than time
  • Can be used to judge a firm's financial performance and evaluate different investment strategies

Disadvantages

  • Does not consider inflation
  • The figures used are only estimates so it must be treated with caution; the longer the investment analyzed the less accurate it is

NPV (HL)

  • It is a financial metric that calculates the difference between the present value of cash inflows and outflows of an investment helping determine its profitability
  • To be able to compare values we must use a present value calculation. We do so by multiplying the expected value in the future by a discount factor to get the "present" value of the future money

Advantage

  • Greater forecasting ability as its more accurate due to consideration of inflation

Disadvantage

  • Forecasting two values: inflation and cash inflow

Discount table example:

Discount Table Example

Exam tip

Note that you are given discount tables in exams so there is no need to worry about memorizing stuff.