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?