Merits and demerits of appraisal methods /financial management
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1. Payback period:
The payback (or payout) period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project, if the project generates constant annual cash inflows, the payback period can be computed dividing cash outlay by the annual cash inflow.
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Payback period = Cash outlay (investment) / Annual cash inflow = C / A
Advantages:
1. A company can have more favourable short-run effects on earnings per share by setting up a shorter payback period.
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2. The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss.
3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the liquidity of the project.
Limitations:
1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
4. Administrative difficulties may be faced in determining the maximum acceptable payback period.
2. Accounting Rate of Return method:
The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profit abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.
ARR= Average income/Average Investment
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Advantages:
1. It is very simple to understand and use.
2. It can be readily calculated using the accounting data.
3. It uses the entire stream of incomes in calculating the accounting rate.
Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. It does not consider the lengths of projects lives.
4. It does not allow for the fact that the profit can be reinvested.
3. Net present value method:
The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.
The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:
The payback (or payout) period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project, if the project generates constant annual cash inflows, the payback period can be computed dividing cash outlay by the annual cash inflow.
ADVERTISEMENTS:
Payback period = Cash outlay (investment) / Annual cash inflow = C / A
Advantages:
1. A company can have more favourable short-run effects on earnings per share by setting up a shorter payback period.
ADVERTISEMENTS:
2. The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss.
3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the liquidity of the project.
Limitations:
1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
4. Administrative difficulties may be faced in determining the maximum acceptable payback period.
2. Accounting Rate of Return method:
The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements, to measure the profit abilities of the investment proposals. The accounting rate of return is found out by dividing the average income after taxes by the average investment.
ARR= Average income/Average Investment
ADVERTISEMENTS:
Advantages:
1. It is very simple to understand and use.
2. It can be readily calculated using the accounting data.
3. It uses the entire stream of incomes in calculating the accounting rate.
Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. It does not consider the lengths of projects lives.
4. It does not allow for the fact that the profit can be reinvested.
3. Net present value method:
The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.
The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:
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