Theory 4 - Theories - Investment - Finance - Business bank - Virtual Bank of Biz/ed

Finance - Investment

Theory 4 - Advantages and disadvantages of investment appraisal techniques

Payback period

  • Advantages
    • It is simple to use and gives an immediate view on how long it will take to recoup an investment
    • May be useful where the time scale is relatively short - it then becomes more important to know how quickly the investment cost is recovered
    • Helps to identify how quickly the cash flow might become positive on the project - useful where firms have cash flow problems
  • Disadvantages
    • Can give an overly simplistic view of the situation
    • Doesn't take account of the fact that future returns may be less valuable
    • Ignores qualitative aspects of the decision
    • Focuses just on the payback period and therefore doesn't look at how much cash is generated after payback is reached
    • Doesn't look at the profitability of project and compare the return to the initial investment
    • Takes no account of what is happening with interest rates

Average rate of return

  • Advantages
    • Clearly shows the profitability of the investment
    • Can take account of interest rate changes
    • Can be used to compare with alternative investment projects to see how rates of return differ
  • Disadvantages
    • Doesn't take account of the fact that future returns may be less valuable
    • Ignores qualitative aspects of the decision
    • Doesn't consider how long it may take to recover initial investment and the costs of finance that may be needed

Net present value (discounted cash flow)

  • Advantages
    • Takes account of interest rates
    • Looks at the profitability of the project
    • Allows for the fact the future returns may be less valuable than current returns and so takes account of the 'opportunity cost' of the money
  • Disadvantages
    • Ignores qualitative aspects of the decision

Why not now have a look at the case study and practice using this technique?