3.3.2 - Investment Appraisal

Question 1

Def investment appraisal

Answer 1

The process of analysing the financial merits of a possible future investment

Question 2

The three methods of investment appraisal

Answer 2

• payback average
• average rate of return
• net present value

Question 3

3 assumptions investment appraisal makes

Answer 3

• cost and revenues can be easily forecasted
• key economic variables don’t change
• business seeks to profit maximise

Question 4

When is investment appraisal used

Answer 4

• will long term investments give the best return?

- projects eg new machinery, premises and research

Question 5

Def payback

Answer 5

Assesses the period of time a business must wait until its initial investment has been recovered allowing a firm to prioritise risk reduction when making investment decisions

Question 6

Formula payback

Answer 6

Month of payback = income needed/ contribution per month

Question 7

Formula for month it occurs

Answer 7

Outlay outstanding/ monthly cash flow in year of payback

Question 8

Description ARR

Answer 8

Considers profit generates by an investment, involves calculating the average annual profit as a percentage of the initial outlay

Question 9

3 steps involved in calculating ARR

Answer 9

1) calculate total profit over the lifetime of the project by adding all net cash flows and deducting the initial outlay
2) divide by the number of years the project lasts
3) apply formula

Question 10

ARR formula

Answer 10

(Average annual profit / initial outlay) x 100

Question 11

Interpretation of ARR

Answer 11

The higher the ARR, the more profitable the investment

Question 12

Description of NPV

Answer 12

Takes into account the money in the future is not worth what it is today, so adds in a discount table to make it more realistic

Question 13

NPV formula

Answer 13

Total discounted cash flows - initial cost of investment

Question 14

Interpretation of NPV

Answer 14

A positive NPV shows a project generates a greater return on initial outlay than simply putting the money in the bank at an investment rate equal to the percentage discounting factor used.

Question 15

Def short termism

Answer 15

Is the tendency to focus on achieving short term objectives by taking decisions that may preclude better, long term options

Question 16

Strengths of payback

Answer 16

• easy to calculate and understand
• more accurate as ignored longer term forecasts
• takes into account the timings of cash flows
• useful for a business with weak cash flows

Question 17

Limitations of payback

Answer 17

• tells us nothing about profitability
• ignores what happens after payback is achieved
• may encourage a shirt-thermistor attitude

Question 18

Strings of ARR

Answer 18

• clear focus on profitability
• considers cash flows over the while projects lifetime
• easy to compare with other measures as expressed as a percentage

Question 19

Limitations of ARR

Answer 19

• ignores the timings of cash flows

- includes forecast data from far in suture which reduces reliability of results

Question 20

Strengths of net present value

Answer 20

• takes the opportunity cost of money into account

- considers both amount and timing of cash flows to indicate profitability

Question 21

Limitations of NPV

Answer 21

• complex to calculate and communicate
• meaning is often misunderstood
• only comparable between different projects if the initial outlay is the same

Question 22

4 other non financial factors affecting investment decisions

Answer 22

Corporate objectives, company finances, confidence in data, social responsibilities