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Finance - InvestmentExplanationInvestment decisions are not a simple matter of looking at an investment and saying 'Yes that looks profitable' and going ahead. Most businesses will have a choice of a range of investment projects and they need to have a basis for comparing them to evaluate which is the best. A part of this evaluation has to be based on a financial assessment of the projects ('qualitative factors') and partly also on non-financial factors ('qualitative decisions'). In this section we look at all these, but on this page we give a brief introduction to the tools available for investment appraisal. Payback period This is the first and one of the simplest appraisal techniques. You simply need to look at the financial returns that the project is expected to generate over all the years of its life and compare these to how much it cost. You then look at how long the investment takes to payback its original cost. The faster the payback, the better. Average rate of return This method also looks at the returns (the net cash flows) over the years of the investment. It then works out how much the average return is over the lifetime of the project, divided by the original cost to get a percentage return. The higher the return, the better. Discounted cash flow This is the most sophisticated and complex of the methods as it takes into account the time value of money. In other words, it takes account of the fact that a return in several years is worth a lot less than having the same return in your hand now. Therefore future returns need to be discounted to see what they would be worth now. Once this has been done, then it is easier to evaluate what the investment may be worth. For more detail on all these methods of investment appraisal, why not have a look at the theory section or perhaps you would like to practice the different investment appraisal techniques on a case study. |
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