• INVESTMENTS refers to the PURCHASE OF AN ASSET, WITH THE POTENTIAL TO YIELD FUTURE FINANCIAL RETURNS, such as upgrading computer equipment or the purchase of a building. With most investments, resources are risked in a decision that might or might not bring about future financial gains 

• INVESTEMENT APPRAISAL refers to the QUANTITATIVE TECHNIQUES USED TO CALCULATE THE FINANCIAL COSTS + BENEFITS (ASSESS THE RISK) OF AN INVESTMENT DECISION, which mot ften uses NET CASH INFLOWS as the basis of the investment's viability. Basically answering "IS IT WORTH IT?"

  • • The three main methods of investment appraisal are: the payback period, the average rate of return and the net present value.

• THE PAYBACK PERIOD (PBP), as the name suggests, refers to the AMOUNT OF TIME (YEARS, MONTHS, DAYS) NEEDED UNTIL THE CUMULATIVE NET CASH INFLOW (DIRECTLY ATTRIBUTED TO THIS INVESTMENT) ARE EQUAL TO THE INITIAL INVESTED FUNDS. In other words: "How long will it take for me to get the $value of my initial investment back!"

--The formula (Not particularly useful tbh) for calculating the PBP is--

 INITIAL INVESTMENT COST / AVERAGE ANNUAL NET CASH INFLOW*) 

*Clearly this formula works out the annual return, and will give a result in this format '3.55', which means what? Well, it means 3 years plus 55% of one year, which is 6.6 months, so the PBP is 3 yrs 6.6 mths.

• PROS:

  • • VERY SIMPLE TO CALCULATE: It’s super easy to calculate — Once you have the net inflows and the li

    • QUICK DECISIONS: Helps businesses quickly see how long it takes to get their money back.

    • LESS RISKY: Projects with short payback periods are less risky if things go wrong.

• CONS:

  • • IGNORES LONG-TERM PROFITABIITY: This method only looks at how fast you get your money back, not how much profit you could make in the future. For example, a company chooses a machine that pays back in 2 years but makes $5,000 total profit rather than another machine takes 4 years to pay back but makes $20,000 total profit.

    • IGNORES THE FACT THAT MONEY LOSES VALUE OVER TIME: The inflows are paid over time and as such $100 today is given the same value as $100 in 5-years, which should be less valuable due to inflation over the lifespan. 

• THE AVERAGE RATE OF RETURN (ARR), calculates the average profit on an investment project expressed as a percentage of the amount invested. The formula for calculating the ARR is:

--The formula for calculating the ARR is--

(TOTAL PROFIT DURING PROJECT'S LIFESPAN / NUMBER OF YEARS*) 

/ INITIAL AMOUNT INVESTED)

*This is equal to the Average profit per year.

• As we said the whole reason for investment is to earn a return on the initial outlay which is expressed as a %, one of the OPPORTUNITY COSTS of using funds to buy investment items is THE INTEREST YOU FORGO BY PLACING YOUR FUNDS IN THE BANK.

• Therefore one of the main influences on whether on not to make an investment in terms of whether its worth the risks is THE CURRENT BASE INTEREST RATE, which is a guaranteed safer return.

• IGNORE TIME VALUE OF MONEY (TVM): ARR treats all future cash inflows equally, failing to account for the fact that money loses value over time.

• DOESN'T CONSIDER THE TIME OF CASH FLOWS: It focuses on average returns and ignores the timing of cash inflows, which can impact liquidity.

• IGNORES RISK & UNCERTAINTY: ARR does not account for risks, inflation, or changing economic conditions, which can affect project viability.

• CAN BE MISLEADING FOR CAPITAL-INTENSIVE PROJECTS: Since ARR focuses on profits rather than cash flows, it may overlook projects with higher initial costs but better long-term cash flows.

Use the above content to explain this:

• "If the base rate is close to the ARR then why take the risk of investing?"

"Would you prefer $1,000,000 today, or $1,000,000 in 5 years time? Justify your answer."

• If you opted to receive the $1,000,000 today, then you made the right choice! Why? Because the present value of the future payment of $1,000,000 will lose its value In terms of their PURCHASING POWER due to TWO FACTORS:

  • • • 1) Assuming INFLATION (The rising average price level) occurs the purchasing power of $1,000,000 in 5 years time will be less as higher prices means the money will buy less than it could at today's prices.

      • 2)...and...without having all the money up front they will miss out on the COMPOUND INTEREST that the $1,000,000 could have earned over 5 years if they deposited it in a bank now. In other words, the OPPORTUNITY COST of getting money in the future is missing out on the compund interest you could have earned by depositing it all now.

• Thus when considering whether to invest or save the 'REAL INTEREST RATE' is needed which is equal to the BANK'S RATE MINUS THE INFLATION RATE.

• THE NET PRESENT VALUE (NPV), is the sum of all discounted cash flows minus the cost of the investment project. As we now know money received in the future is worth less than if it were received today, so the longer the time period of the project under consideration, the lower the present value of that future amount of money.

NPV is calculated by using the formula:

NPV = SUM OF PRESENT VALUE - COST OF INVESTMENT

• The original amount invested is often referred to as the principal or capital outlay. 

  • • • If the NPV is POSITIVE it means the value of the discounted (future) net cash flows are GREATER THAN THE INITIAL INVESTMENT, and therefore shoild be considered.*

      • If the NPV is NEGATIVE, then the investment project is NOT WORTH PURSUING on financial grounds.

        • • • *Don't forget we have based the NPV on an EXPECTED REAL INTEREST RATE, however IN REALITY the EXPECTED BANK RATE and the EXPECTED INFLATION RATE could change.