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What is Investment appraisal?

The process of analysing whether investment projects are worthwhile.

Three main methods

 Payback period
 Net present value
 Average rate of return

Payback period

The payback periods are the time it takes for a project to repay its initial investments.

Net present value

Net present value (NPV) calculates the monetary value now of the project future cash flows.

Average rate of return

The average method looks at the total accounting return for a project to see if it meets the target
return.

Calculating ARR

ARR (%) = (Total net profit /No years) divided by (initial costs) x 100

Advantages

ARR provides a percentage of the return which can be compared with a target return.

ARR looks at the whole profitability of the project

Focuses on profitability – a key issue for shareholders

Disadvantages

Does not consider cash flows – only profits (they may not be the same thing)

Takes in account of the time value of money

Treats profits arising late in the project in the same way as those which might arise early

The value of setting financial objective?

- A focus for the entire business

- Important measure of success or failure for the business
- Help reduce the risk of business failure
- Provide transparency for shareholders about their investment
- Help coordinate the different business functions
- Key context for making investments decisions

Benefit of high gearing

- Less capital required to be invested by shareholders

- Debt can be a relatively cheap source of finance compared with dividends
 - Easy to pay interest if profits and cash flows are strong

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Some examples cash flow objectives

- Reduce borrowing to target level

- Stay below limit for gearing %
- Minimise interest costs
- Reduce amounts held in inventories or owed by customers
- Reduce seasonal swings in cash flows

How a business can improve it cash flow

- Low profits or losses

- To much production capacity
- Excess inventories held
- Allowing customers to much credit and too long to pay
- Overtrading (fast growth)
- Seasonal demand

Why does long run average cure is called envelope cure its because it envelopes all short run
average cost curves

It illustrates how average cost initially decreases due to economies of scale while the firm
experiences increasing returns to scale.

Contribution is what a business needs to achieve from selling products in order to first cover its
fixed costs and, thereafter, make a profit