3.7 Investment appraisal

Question 1

Investment appraisal-

Answer 1

process of analysing whether investment projects are worthwhile- helps business decide what
projects to invest in, to get the best, fastest least risky return for their money.
§ Faster money comes in – less risk

Question 2

Must balance risk and return:

Answer 2

§ Businesses often need to invest to achieve their objectives.
Investment is always risky – businesses want risk to be
low and reward high

Question 3

+VE ARR

Answer 3

§ Easy to calculate and simple to understand
§ Focuses on the overall profitability of an investment project
§ Easy to compare ARR with other key target rates of return to help decide
§ Uses all the return generated by a project
§ Takes account of all projects cash flow after a certain point

Question 4

Disadvantages: ARR

Answer 4

§ Ignores timing of the cash flows
e.g. a company might put more
value on money that they get
sooner rather than later
§ Focuses on profits rather than cash
flows
§ Ignores time value of money

Question 5

Advantages PAYBACK

Answer 5

§ Easy to calculate and understand
§ Focuses on cash flows
§ Emphasises speed of return; good for markets which change rapidly. Straight forward to compare competing proj
§ Very good for high tech projects. Tech tends to become obsolete so businesses need to be sure they’ll get initial
investment back or any project that might not provide long term returns

Question 6

-VE PAYBAK

Answer 6

§ Ignores cash flow after
payback has been reached
§ Takes no account of the
‘time value of money’ (risk)
§ May encourage s/t thinking
§ Ignores qualitative aspects
§ Doesn’t actually create a
decision for the investment

Question 7

what is discounting
what is the discount rate
what does it depend on
what does present value represent

Answer 7

Discounting- method used to reduce the future value of cash flows to reflect the risk that they may not happen
§ Done so investors can compare like with like when they look at cash inflows they’ll receive
§ Can be seen as the opposite of calculating interest. Done by multiplying the amount of money by a discount
factor. Discount rate= always less than 1 - value of money in future is always less than its value now
§ Depend on what the interest rate is predicted to be. High interest rates – future payments have to be
discounted a lot to give correct present value= present value represents the opportunity cost of not investing in
bank – earn a high interest rate
§ Interest rates are low- future cash inflow doesn’t need to be discounted – less OC

Question 8

what does the future value of cash inflow depend on

Answer 8

risk and opportunity cost
§ Risk and opportunity cost – increase the longer you have to wait for money- it’s worth less
§ This is called the time value of money. Better off getting money now: years time money is worth less – inflation.
There’s an OC

Question 9

what does time value of money suggest

Answer 9

The time value of money:
§ Better to receive cash now than in future
§ Future cash flows worth less
§ Use discount factor
§ Cash flow X discount factor= present value

Question 10

what is discounted cash flow
what is net present value
what does a negative NPV suggest
what should businesses go a head with

Answer 10

Net present value is used to calculate return
§ Discounted cash flow is an investment appraisal tool that uses NPV to calculate return of project
§ Net present value – value of project assuming all future returns are discounted to what they would be worth if
you had them now, always less than their face value (inflation). Add together all present values of future cash
flows
Negative NPV- business could get a better return by putting money in savings account. Businesses go ahead with
positive NPV.

Question 11

Downsides of discounted cash flow-

Answer 11

flow- hard to calculate- difficult for businesses to work out what the discount factor
ought to be- because they don’t know what the bank I/R are going to be in future. The longer the project is set to
last, the harder it’s to predict discount factor

Question 12

Downsides of discounted cash flow-

Answer 12

flow- hard to calculate- difficult for businesses to work out what the discount factor
ought to be- because they don’t know what the bank I/R are going to be in future. The longer the project is set to
last, the harder it’s to predict discount factor

Question 13

Benefits of using NPV:

Answer 13

§ Considers all future cash flows
§ Reflects risk that future cash flows will not be as expected
§ Different levels of risk can be accounted for by adjusting discount rate
§ Creates a straight forward decision positive NPV suggests project should go ahead

Question 14

Disadvantages: of npv

Answer 14

§ Most complicated method
§ Choosing discount rate is hard, esp for long projects
§ Result can be influenced/ manipulated using the discount rate

Question 15

Disadvantages: of npv

Answer 15

§ Most complicated method
§ Choosing discount rate is hard, esp for long projects
§ Result can be influenced/ manipulated using the discount rate

Question 16

Non – numerical, qualitative factors affect investment decisions:

Answer 16

RTNN
- busin. obj. and strategy
-corporate image
-industiral relation

Question 17

why is there always a rish adn uncertainty
what is a good idea to do

Answer 17

-§ All investment appraisal methods are based on predictions about how much income they can generate from
investments. Difficult to accurately predict whats going to happen in future, cant always rely on predictions.
§ Market environments are always uncertain- circumstances might change unexpectedly – negative impact.
Exchange rates may alter, sales may decrease, tastes may change
§ Any change in circumstances that business base their investment predictions on mean their predictions no
longer valid
§ Every firm has a different attitude to risk- some happy to take big risks- financial reward
§ Good idea to have a set of investment criteria- conditions that need to be met for investment to be approves.

Question 18

what is sensitivity analysis
what is base case

Answer 18

• a technique which allows the analysis of changes in assumptions used in forecasts
  Most decisions rely on certain assumptions about future events e.g. an investment decision might be based on the
  assumption that the price of raw materials will increase by 8% over next 3 years, sales rev increase by 3% each
  year- make a scenario for future called base case

Question 19

some invest ment assumptions

Answer 19

Assumptions:
§ Investment appraisal- timing and amount of project cash flows, period over which project will run, amount of
initial investment

Question 20

questons that sens ansal can help answer

Answer 20

Sensitivity analysis:
§ How reliable assumptions made
§ What happens if assumption turn out to be sig different in reality
§ Which assumptions most significant to forecast
Looks at the base case and considers what would happen if you alter the assumption, e.g. raw mat increase by 10
to 15%. Analysing several factors – specialist software

Question 21

sens analy +ve

Answer 21

§ Allows key assumptions to be changed to analyse effect
§ Helps judge degree of risk in an investment project
§ Recognises that there is no such things as an accurate forecast
§ Considers one variable or assumption at a time
§ Identifies the most significant assumption (requires closer attention)
§ Helps assess risk and prepare for less than favourable scenario
§ Helps make the process of business forecasting more robust

Question 22

sens analy -ve

Answer 22

§ Only tests one assumption at a
time
§ Only as goods as data on which
forecasts are based
§ A somewhat complicated
concept- not understood by all
managers

Question 23

finacial and non finacial facctors infl invest ment decsions

Answer 23

Financial:
§ Investment criteria
§ Total returns and sensitivity
§ Alternative investments
§ Financial position
Non-financial factors:
§ Corporate objectives
§ Organisational culture and attitude to risk
§ Management confidence in the investment appraisal data
§ Business image and reputation