IB Business and Management ACCOUNTS AND FINANCE 3.2 Investment Appraisal
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MrBurton Plus on August 1, 2012
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IB Business and Management ACCOUNTS AND FINANCE 3.2 Investment Appraisal
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15 terms
Terms | Definitions |
|---|---|
 Investment appraisal | Evaluating the profitability or desirability of an investment project |
| Information quantitative investment appraisal requires: | 1. Initial capital costs of the investment 2. Estimated life expectancy 3. The expected residual value (additional net returns from the sale of the asset at the end of its useful life) 4. Forecasted net returns or net cash flows from the project (expected returns less running costs) |
| Methods of quantitative investment appraisal | 1. Payback period 2. Average rate of return 3. Net present value using discounted cash flows |
| How external factors (future uncertainty) can influence revenue forecasts: | 1. Economic recession could reduce demand 2. Increases in oil prices may increase costs of production 3. Interest rates may decrease (both reducing costs of finance and inflating future returns) |
| Payback period | The length of time it takes for net cash inflows to pay back the original capital costs of the investment |
| Average rate of return ARR | Measures the annual profitability of an investment as a percentage of the initial investment |
| 4 stages in calculating ARR | 1. Add up all positive cash flows 2. Subtract cost of investment 3. Divide by lifespan 4. Calculate the % return to find the ARR |
| Criterion rate or level | The minimum level (maximum for payback period) set by management for investment appraisal results for a project to be accepted |
| Why future cashflows are discounted | 1. Inflation: The same amount of money in the future will not purchase the same amount of goods and services as it can today 2. Interest foregone: Money can be invested for a return. If you invested the money safely now, it will be worth more in the future. 3. Uncertainty: The cash today is certain, but the future cash on offer is always associated with at least a degree of risk and uncertainty |
| The present value of a future sum of money depends on two factors: | 1. The higher the interest rate, the less value future cash in today's money 2. The longer into the future cash is received, the less value it has today |
| Net present value (NPV) | Today's value of the estimated cash flows resulting from an investment |
| Qualitative investment appraisal | Assessing non-numeric information in examining an investment choice |
| Examples of qualitative factors in investment appraisal | 1. Impact on the environment 2. Planning permission (will local governments allow the investment?) 3. Aims and objectives of the business 4. Risk |
| 3 stages in calculating NPV | 1. Multiply discount factors by the cash flows (cashflows in year 0 are never discounted) 2. Add the discounted cashflows 3. Subtract the capital cost to give the NPV |
| Factors in assessing an ARR percentage value | 1. The ARR on other projects (the opportunity costs) 2. The minimum expected return set by the business (the criterion rate) 3. The annual interest rate on loans (ARR needs to be greater than the interest costs of borrowing; even if the firm doesn't need to borrow there's always an opportunity cost of interest foregone by keeping the money in the bank) |
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