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Investment Appraisal: A Simple Introduction

Investment Appraisal: A Simple Introduction

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Investment Appraisal: A Simple Introduction

3.5/5 (5 valutazioni)
82 pagine
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Nov 11, 2013


Investment Appraisal: A Simple Introduction offers an accessible guide to the methods and uses of investment appraisal, with examples and calculations throughout.

Understand the accounting rate of return (ARR), the payback period (PP), the net present value (NPV), and the internal rate of return (IRR). Work through four extended example studies for each approach, and learn how to easily find the NPV or IRR with Excel.

Compare the strengths and weaknesses of each of the four appraisal methods, and examine potential errors, risk management, and project management.

Nov 11, 2013

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Investment Appraisal - K.H. Erickson

Investment Appraisal: A Simple Introduction

By K.H. Erickson

Copyright © 2013 K.H. Erickson

All rights reserved.

No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the author.

Also by K.H. Erickson

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Table of Contents

1 Introduction

2 Accounting Rate of Return (ARR)

2.1 ARR and ROCE Explained

2.2 ARR Extended Examples

2.3 Problems with ARR

3 Payback Period (PP)

3.1 Payback Period Explained

3.2 Payback Period Extended Examples

3.3 Problems with Payback Period

4 Net Present Value (NPV)

4.1 NPV Explained

4.2 NPV Using Discount Tables and Excel

4.3 NPV Extended Examples

5 Internal Rate of Return (IRR)

5.1 IRR Explained

5.2 IRR Extended Examples, IRR in Excel

5.3 Problems with IRR

6 Investment Appraisal in Practice

6.1 Potential Sources of Error

6.2 Risk Management

6.3 Project Management

1 Introduction

In order to survive and grow businesses must make decisions involving investments in new buildings, vehicles, machinery, equipment, shares, or other long-term assets. The central feature of these decisions is time, and an investment involves incurring financial costs at one point in time to gain greater benefits at another, usually later, point in time. This outlay also typically comes as one large investment, while the benefits will usually arrive in smaller amounts over an extended period.

Making the correct investment decisions is crucial to a business for two main reasons. First, the investments will often involve significant amounts of resources, and a business may make an expenditure representing a large proportion of their total wealth and assets. If the decision is made poorly then it could have damaging or even devastating effects on the future of the business. Second, it may be impossible or very expensive to abandon an investment project once it has begun. An investment made by a business will typically be tailored to its own unique needs, and this specialization is likely to limit the value it holds to other possible users who will naturally have different needs, and in turn reduce the money that could be recouped from the investment.

Investment decisions are of vital importance to the viability of a business, and as a result it’s essential that all investment proposals are properly screened before they proceed. A crucial part of this screening process is the use of appropriate methods of evaluation and appraisal. In practice there are four basic methods used by businesses worldwide to evaluate investment opportunities, noting that ARR and ROCE follow the same approach:

1) Accounting rate of return (ARR) / return on capital employed (ROCE);

2) Payback period (PP);

3) Net present value (NPV);

4) Internal rate of return (IRR).

Some businesses may use a variation of these four methods, and others may not use any investment appraisal method at all, ignoring facts and figures to instead make decisions based on emotions and what feels right. But in practice most businesses around the world appear to use one of the four methods listed above.

The next four chapters explain and assess each of the appraisal methods in turn, using a range of numerical examples to show how the method is calculated, and investigate the strengths and weaknesses associated with each measure while making comparisons between them. Simple steps to calculate the NPV and IRR of projects using Excel are also given, to facilitate quicker and easier investment appraisal. The final chapter looks at how project appraisal is conducted in practice, and the additional issues that a business may need to manage.

2 Accounting Rate of Return (ARR)

2.1 ARR and ROCE Explained

The accounting rate of return (ARR) takes the average annual accounting profit that an investment is expected to generate, before expressing it as a percentage of the average investment made in the project to earn that profit, measured in accounting terms:

ARR = (Average annual profit / Average investment) x 100%

For example, it may already be known that the average annual profit for a project is £20,000 and its average investment is £80,000.

ARR = (£20,000 / £80,000) x 100%

= 0.25 x 100%

= 25%

Alternatively, the information may not be so easily presented, and some additional calculations may have to be made. Perhaps a business invests £50,000 at the start of an investment project, and another £40,000 after one year, making a total of two investments. In return it expects to achieve an income stream of £110,000 each year over the next five years, starting from the time of the initial investment.

Average annual investment profit = £110,000 / 5

= £22,000

Average investment = (£50,000 + £40,000) / 2

= £90,000 / 2

= £45,000

ARR = (£22,000 / £45,000) x 100%

= 0.4889 x 100%

= 48.89%

These calculations are quite simple, and the formula and examples here give the general idea of what the accounting rate of return is all about.


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    1 persona l'ha trovata utile

    It is very simple to understand, logically presented to accommodate all relevant investment appraisal methods, both in theory and apparent practice. It is a very good material for understanding the basics of investment appraisal theory and practice, well exemplified.

    1 persona l'ha trovata utile