CBT

formula

ratio meaning

benchmarking

analysis of ratio

main interestedadvantages

disadvantages

page

average annual operating accounting profit/ average rate of return investment to earn (ARR) that profit X 100 %

it is similar than ROCE Unlike other methods of investment appraisal, the ARR is based on profits rather than cashflow . So it is but the main affected by subjective, non-cash items such as the rate of depreciation you use to calculate profits. difference is that it higher the ARR, the more The The ARR also fails to take into account the timing of profits. In calculating ARR, a 100,000 profit five measures the attractive the investment is. You The main advantage isyears aw ay is given just as much w eight as a 100,000 profit next year. In reality, you would prefer to that performance of a can compare the ARR to your ow n it is easy to understand, the profit sooner rather than later. See the page in this guide on discounting future cashflow . get The accounting rate of return (ARR) is a before it company target rate of return, and to the due to is expressed in There are also several different formulas that can be used to calculate an ARR. If you use the ARR to w ay of comparing the profits you performed. ARR on other potential has percentage. A w ay to compare different investments, you must be sure that you are calculating the ARR on a consistent expect to make from an investment to Comparing to others investments. It also says how to shareholder evaluate managementbasis. the amount you need to invest.the higher attractive and investment is investors, performance. 349 Payback period ignores the value of any cashflows once the initial investment has been repaid. For example, two projects could both have a payback period of four years, but one might be expected to produce no further return after five years, while the other might continue generating cash indefinitely. Although payback period focuses on relatively short-term cashflows, it fails to take into account the time-value of money. For example, a 100,000 investment that produced no cashflow until the fourth year - and then a payback of 100,000 - w ould have the same four-year payback period as an investment that produced an annual cashflow of 25,000. In reality, the first is likely to be a riskier and less attractive investment. A more complex version of payback period can be calculated using discounted cashflow s. This gives more w eight to cashflow s you expect to receive sooner. See the page in this guide on discounting future cashflow . Payback period ignores the value of any cashflows once the initial investment has been repaid. For example, tw o projects could both have a payback period of four years, but one might simple to compute , easy expected to produce no further return after five years, w hile the other might continue generating be to understand and can offer indefinitely. cash liquidity insight. 354

payback period days

Payback period is a simple technique for assessing an investment by the length of time it w ould take to repay it. you initially investment back in It is usually the default technique for three years, because the period smaller businesses and focusescompafring to others years. Which means that the on is 5 cashflow, not profit. Also is takes into the shortest payback payback period should be shorter accpunt the timing. period. Also than the lenght of the project. The NPV calculates the present value of all cashflow associated w ith an investment: the initial investment outflow and the future cashflow returns. The higher the NPV the better. If it is positive then the company For example, if an investment of should be advised to carry on and 100,000 generates annual cashflow of implement it the project. is 28,000 and you discount at 10 per cent, positive means we are making the NPV for five years of cashflow is money in terms of cash the 6,142. How ever, if the annual cashflow project can exist w ithout having starts at 26,000 and goes up by 1,000 a payback period. If the NPV is year, giving the same total amount of from 1 to 5 means that the cash over five years - 140,000 - the project might be subject to the N PV, using a discount rate of 10 per variation of the cash flow. cent, w ill be 5,422. Alternatively, you can work out the discount rate that w ould give an investment an NPV of zero. This is called the IRR. The higher the IRR the better. You can compare the IRR to your ow n cost of capital, or the IRR on alternative projects. Is a discount rate that when applied to its future cash flow s, w ill produce an N PV of zero.higher the better. the

net present value money

It tells w hether the investment w ill increase he IRR are sophisticated and relatively complicated w ays of evaluating a potential investment NPV and firms value. Considers all Choosing the right discount rate to use to calculate NPV is difficult. The discount rate needs to take the cash flows. Considers account the riskiness of an investment project and should at least match your cost of capital. The into the time value of the NPV calculations unlike IRR method, expects the management to know the true money. Considers the cost of capital. risk of future cash flow s, NPV gives distorted comparisons between projects of unequal size or unequal the fact that money you expect economic life. In other to overcome this limitation, NPV is used w ith the profitability sooner is w orth more to index. you than money you expect further in the future. 364

IRR internal rate of return %

It tells w hether the investment w ill increase he firms value. Considers all not be used in situations w here the sign of the cash flow s of the project change more than once can the cash flows. Considers during the project. Reuires an estimate of the cost of capital. M ay not give the value maximizing the time value of the decision w hen ias used to compare two projects. Not helpful for comparing tw o mutually exclusive money. investment because it completely ignores the scales of investment. 368