3.3.2 Investment Appraisal

Question 1

What is average rate of return or accounting rate of return (ARR)?

Answer 1

A method of investment appraisal that measures the net return per annum as a percentage of the initial spending.

Question 2

What is the Capital cost?

Answer 2

The amount of money spent when setting up a venture

Question 3

What is discounted cash flow (DCF) ?

Answer 3

A method of investment appraisal that takes interest rates into account by calculating the present value of future income

Question 4

What is an Investment

Answer 4

The purchase of capital goods

Question 5

What is an investment appraisal?

Answer 5

The evaluation of an investment project to determine whether or not it is likely to be worthwhile

Question 6

What is a net cash flow

Answer 6

Cash inflows minus cash outflows

Question 7

What is Net present value (NPV)

Answer 7

the present value of future income from an investment project, minus the cost

Question 8

What is Payback period

Answer 8

The amount of time it takes to recover the cost of an investment project

Question 9

What is Present value

Answer 9

The value today of a sum of money available in the future.

Question 10

Advantages of the payback method

Answer 10

• This method is useful when technology changes rapidly as it is important to recover the cost of investment for a new model equipment is designed.
  -It is simple to use.
  -Firms might adopt this method if they have cash flow problems. This is because the project use and will ‘pay back’ the investment more quickly than others.

Question 11

Average rate of return (ARR)?

Answer 11

(Net return (profit ) per annum) / (Capital outlay (Cost)) x 100

Question 12

Advantages of the ARR method

Answer 12

The advantage of this method is that it shows clearly the possibility of an investment project. Not only does it allow a range of products to be compared. The overall rate of return can be compared to other uses for investment funds.

Question 13

What are two features of discounting?

Answer 13

• The higher the rate of discount, unless the present value of cash flow in the future. This is the reverse of saying that the higher rate of interest the greater will be the value of an investment in the future
  -The Further into the future, the cash flow or earnings from an investment project, the less is the present value.

Question 14

Advantages of the discounted cash- flow method?

Answer 14

• The discounted cash flow method, unlike the payback method, and the average rate of return currently accounts for the value of the future earnings by calculating present values.
  -The discount rate used to can be changed as risk and conditions in the financial markets change. For example, in the 1990s, the cost of bank borrowing for many businesses fell from over 15% to 7 to 8%. Investment projects therefore did not need to make such a high rate of return to be profitable and so the rate of discounts could be lowered.

Question 15

Limitations of discounted cash flow?

Answer 15

-The calculation is more complex than the other methods.
- The rate of discount is critical. If it is high, fewer projects will be profitable.

Question 16

Limitations of investment appraisal ?

Answer 16

• Payback limitations; very simple, only looks at speed of payback and dopes not look at profitability

• ARR limitations; Does not take into account the effects of time on the value of money

• NPV limitations; Very complex, not used by small business, also results dependent on rate of discount used, the higher the rate the more likely it is that the project will be rejected as unprofitable