Bm Unit 3.2 Investment Appraisal


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IB Business and Management (Standard Level)
All material taken from the IB Business and Management Textbook:
"Business and Management", Paul Hoang, IBID Press, Victoria, 2007

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Bm Unit 3.2 Investment Appraisal

  1. 1. IB Business and Management<br />Unit 3.2: Investment Appraisal<br />Lesson 1: Quantitative and Qualitative investment appraisal methods<br />pp. 349-353<br />
  2. 2. 1a. Think about it…<br />“Never let a poor man advise you on investments.” – Spanish proverb<br />Why not?<br />What is an investment?<br />The purchase of an asset with the potential to yield future financial benefits.<br />Basically, it is something you buy that you hope will make you money.<br />Can you think of some investments?<br />What makes these investments good or bad?<br />…<br />
  3. 3. 1b. Think about it…<br />What is an investment appraisal?<br />Is the quantitative (means in this case dealing with numbers) techniques used to calculate the financial costs and benefits of an investment decision.<br />There are four main appraisal methods:<br />1. Payback period (standard level)<br />2. Accounting rate of return (standard level)<br />3. Discounted cash flows (Higher level)<br />4. Net present value (Higher level)<br />Since this is a standard IB course, we will be focusing on 1 and 2.<br />…<br />
  4. 4. 2a. Payback period<br />It is the period of time for an investment to earn enough profits to repay the cost of the investment.<br />The formula: initial investment($)<br /> contribution per month($)<br />So your firm buys a new printing machine at a cost of $20,000. It brings in $12,000 in revenue each year. What would the payback period be?<br />Lets work it out: initial investment ($)  $20,000 = ?<br />contribution per month($) ($12,000/12 months)<br />Answer is: 20 months.<br />Now, which would you rather have, a shorter or a longer payback period? Why?<br />Something else to consider when investing: <br />1.Will the income stream from the investment be constant each year?<br />2. You can see an example of this: The cumulative cash flow method on page 351 in your text.<br />
  5. 5. 2b. Payback period<br />Advantages<br />disadvantages<br />Quick and easy to use.<br />Useful if your firm has a cash flow problem.<br />Allows you to see the break-even on the purchase before it needs to be replaced.<br />Used to compare different investments: looking for the quickest payback period.<br />Asses projects that yield quick returns (profits) for investors.<br />Assess the short term, less forecasting errors.<br />May cause short-termism: you may focus only on short term investments.<br />Monthly contributions will vary and will not be constant.<br />This method focuses on time and not on profits…which is the major aim of most businesses.<br />…<br />
  6. 6. 3a. Accounting rate of return<br />This method calculates the average profit on an investment as a % of the amount invested.<br />The formula: APR = total profits during projects / number of years of projects x100<br /> initial amount invested ($)<br />Why is this useful? <br />The APR allows you the manager, to compare the rates of returns on other investment projects.<br />Used to assess the risks and rewards involved in an investment.<br />For example: if an APR is 12% on a project vs. 4% in interest rate on savings, the real rate of return is 8%. So it might be worth the risk to invest on the project vs. to saving your money.<br />Turn to page 353 in your text for another example on how to calculate APR.<br />
  7. 7. 3b. Accounting rate of return<br />Advantages<br />disadvantages<br />Enables easy comparisons of different investment projects.<br />You are looking for the investment which provides the most return for less money invested.<br />It ignores the timing of cash inflows.<br />Prone to forecasting errors.<br />…<br />
  8. 8. End<br />