INVESTMENT APPRAISAL

Question 1

Investment Appraisal

Answer 1

The quantitative techniques used in evaluating the viability or attractiveness of an investment proposal. It aims to establish whether a particular business venture is worth pursuing and whether it will be profitable.

Question 2

3 methods:

Answer 2

1. Payback period
2. Average rate of return
3. Net present value

Question 3

Payback period

Answer 3

Estimates the length of time required for an investment project to pay back its initial cost outlay.

Question 4

Payback period formula

Answer 4

Initial investment cost / Annual cash flow from investment

Question 5

Cummulative cashflows

Answer 5

When the yearly cashflows are different. The cummulative cashflow must be calculated first.

Formula: extra cash inflow required / annual net cashflow in the next year x 12

Extra cash inflow needed: Last negative number of cummulative cash flows

Question 6

Advantages of payback period

Answer 6

• Simple and fast to calculate
• Useful method in rapidly changing industries. Helps estimate how fast the initial investment will be recovered before purchasing a new machine.
• Helps firms with cashflow problems.
• Since it is a short term forecast, less likely to have inaccuracies.

Question 7

Disadvantages of payback period

Answer 7

• Does not consider cash earned after payback period, could influence major investment decisions.
• Ignores profitability of invetsment
• Annual cash flows could be affected by unexpected external changes in demand.

Question 8

Average rate of return

Answer 8

Measures the annual net return on an investment as a percentage of its capital cost.

Question 9

Average rate of return formula

Answer 9

((total returns - capital cost) / years of usage) / capital cost x 100

Question 10

Advantages of Average Rate of Return

Answer 10

• Unlike payback period, it makes use of all the cash flows in a business.
• Allows for easy comparisons with other competing projects for better allocation of investment funds.

Question 11

Disadvantages of Average Rate of Return

Answer 11

• Considers a longer time period, innacuracies in forecasting are more likely.
• Does not consider the timing of cash inflows. Two proejcts would have the same ARR but one pays back faster.
• The effects on the time value of money are not considered.

Question 12

Net Present Value

Answer 12

The difference in the summation of present values of future returns and the original cost of investment.

Question 13

Net Present Value Formula

Answer 13

Total present values - original cost

Question 14

Net Present Value Formula Advatages

Answer 14

• The opportunity cost and time value for money is put into consideration in its calculation.
• All cashflows, including their timing, are included
• The discount rate can be changed to suit any expected changes in economic variables, such as intrerest rate variations.

Question 15

Net Present Value Formula Disadvantages

Answer 15

• More complicated to calculate
• Can only compare invetment projects with the same initial cost outlay
• The disocunt rate greatly infleunces the final NPV result, which may be affected by inaccurate interest rate predicitions.

Question 16

Discounted cash flow

Answer 16

uses a discount factor that converts future cash flows to their present value.