Investment Appraisal (Copy)

4.4 Investment Appraisal Cheat Sheet

1. Key Concepts

• Capital Investment: Large, long-term investment made to improve or expand business operations.
• Net Cash Flows: The difference between cash inflows and outflows from an investment, considered over time.
• Accounting Profit vs. Cash Flow:
  • Accounting Profit: Profit based on accounting rules and depreciation.
  • Cash Flow: Actual inflows and outflows of cash, ignoring accounting adjustments like depreciation.

2. Capital Investment Appraisal Techniques

1. Payback Period
   • Formula: Payback Period = Initial Investment / Annual Cash Inflow
   • Advantages:
     • Simple to calculate and understand.
     • Helps measure liquidity risk.
   • Disadvantages:
     • Ignores the time value of money.
     • Does not consider cash flows beyond the payback period.
     • Ignores profitability.
2. Accounting Rate of Return (ARR)
   • Formula: ARR = (Average Annual Profit / Average Investment) × 100
   • Advantages:
     • Easy to calculate.
     • Useful for comparing projects of different sizes.
   • Disadvantages:
     • Ignores the time value of money.
     • Based on accounting profits, not actual cash flows.
     • Does not account for the length of the investment period.
3. Net Present Value (NPV)
   • Formula: NPV = Σ (Cash Inflows / (1 + Discount Rate)^t) – Initial Investment
   • Advantages:
     • Accounts for the time value of money.
     • Provides a clear measure of the actual profitability of an investment.
   • Disadvantages:
     • Requires an accurate discount rate.
     • More complex to calculate than ARR or payback.
     • Sensitive to assumptions about future cash flows.
4. Internal Rate of Return (IRR)
   • Definition: The discount rate that makes the NPV of the project equal to zero.
   • Advantages:
     • Reflects the rate of return of a project, useful for comparison.
     • Takes the time value of money into account.
   • Disadvantages:
     • May have multiple IRRs for projects with non-conventional cash flows.
     • Difficult to calculate manually; requires software or financial tools.
     • Not suitable for mutually exclusive projects with different sizes.

3. Non-Financial Considerations

• Strategic Fit: How well the investment aligns with the company’s long-term goals.
• Risk: The level of uncertainty surrounding the investment’s future cash flows.
• Environmental Impact: Any environmental considerations or regulations the project might involve.
• Social Impact: How the investment affects stakeholders, such as employees, customers, or communities.
• Technological Advancement: Potential for innovation or improved production techniques from the investment.

4. Decision Making

• Investment Decision: Based on the calculated appraisal techniques and non-financial factors.
• Recommendation: A comprehensive recommendation is made after evaluating financial and non-financial factors.

5. Summary of Techniques

6. Final Recommendation

• Use a combination of financial and non-financial considerations when making an investment decision.
• Prefer NPV and IRR over simpler methods (payback and ARR), as they reflect the time value of money.