<aside> 💡 Investment means purchasing goods. Refers to capital expenditure of a business (expenses of buying fixed assets for a return)

Quantifying the financial risk of a decision. Examining the cost and return of investment.

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• Payback period:

  • Time taken for the initial amount of money invested to be repaid.

  • Analyze the time taken to reach the break-even point.

  • Years or months.

  • Cost of Investment / Contribution per Month (Selling price - VC)

  • The risk on investment is less if the payback period is low.

  • If the net cash flow is not the same for each time period, then the formula can not be used.

  • If it's not equal, we use cumulative cash flow.

    • Identify the year in which the cumulative net cash flow is equal to, or greater than the initial cost of investment.
    • Calculate the monthly net cash flow for that year. (that has the cumulative net cash flow equal/greater to the initial cost of investment)
    • Compare with monthly net cash flow for the year with the previous year’s monthly net cash flow.
    • The difference is then divided by the answer in the third.

    Year	Net Cash Flow	Cumulative Forecast
    1	120	120
    2	140	260
    3	180	440
    4	150	590
    5	110	700
    Investment	380

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    Advantages of Payback Period	Disadvantages of Payback Period
    Easy and fast method to calculate, easier to understand.	Not considering the value of money/timing of cash flow. Money earned now will be less than a few days time.
    Can be used by bu8x sinesses that have cash flow problems and survive recessions.	No consideration of the net payback period.
    Helps in Decision Making, managers will choose to invest with ones that have the shortest payback period.	Consideration of benefits is nonexistent after the PB period.
    	Doesn’t reveal the profitability of an investment. But focuses on the length of time needed to recoup the costs of the project.

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  ARR (Average Rate of Return)

  • That calculates the annual profit of an investment project expressed as a percentage of the initial amount of money invested in the project.
  • Expressed as a percentage of the initial amount invested into the project.
  • (Total returns - Capital Cost) / years of use/capital cost * 100
  • Average annual profit/Initial Investment Cost *100
  • Higher ARR means a Better Investment Position

  Advantages	Disadvantages
  Easy to calculate	Ignores future cash flow timing
  Can be used by managers and evaluate the performance of the business.	Don’t take into consideration the time value of money
  Compare the attractiveness of different investment objects.	Focuses on profits than cash flow.
  And ARR uses estimates to calculate.

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  NPV (Net Present Value)

  • Investment appraisal method
  • The real value of the investment proposal.
  • The sum of the present value - Cost of Investment
  • NPV = All discounted values of future net cash flow added up - Cost of Investment