3.3.2 Investment Appraisal

Question 1

investment

Answer 1

spending now with the expectation of a return in the future

Question 2

Capital investment

Answer 2

machinery and equipment that has a long term benefit

Question 3

Revenue investment

Answer 3

spending on stock, wages that has a short-term benefit

Question 4

Investment appraisal

Answer 4

a series of techniques designed to assist businesses in judging the desirability of investing in particular projects

Question 5

What does investment include decisions on?

Answer 5

• introducing new products
• expansion
• new technology
• advertising campaigns

Question 6

What is payback?

Answer 6

the length of time that it takes for an investment to pay for itself from the net returns provided by that particular investment

Question 7

What is the payback formula?

Answer 7

number of full years + (what you need/what you get) x 12

Question 8

Advantages of payback

Answer 8

• easy to calculate
• takes into account the cost of the investment
• focuses on short-term cash flow as a priority

Question 9

Disadvantages of payback

Answer 9

• ignores the overall return on a project
• ignores the time-value of money
• encourages a short-term approach

Question 10

Average rate of return

Answer 10

a method of investment appraisal which measures the net return per annum as a percentage of the initial spending

Question 11

How to calculate ARR?

Answer 11

1. calculate total profit
   (total net cash flow - investment outlay)
2. average profit = total profit / number of years
3. ARR= (average profit/ initial costs) x100

Question 12

ARR advantages

Answer 12

• measures profitability
• easy to compare % returns against other investments
• considers total profit made

Question 13

ARR disadvantages

Answer 13

• ignores the timings of cash flows
• ignores the time value of money
• ignores the risk that projections of future sales may be more inaccurate the further into the future they are

Question 14

What is Net present value only?

Answer 14

the present value of future income from an investment appraisal
-takes into account time and the value of money

Question 15

What is a discount factor (NPV)?

Answer 15

a discount factor is given to reduce the present value of a future income
-the discount factor takes into account the interest, or return the investment could have had if it has been put in the bank or spent on something else

Question 16

3 steps for calculating the NPV

Answer 16

1. multiply net cash flow x discount factor
2. add up all the present values
3. substrate the initial outlay

Question 17

What is the formula for NPV?

Answer 17

NPV = total income - initial cost of investment

Question 18

Advantages of NPV

Answer 18

• considers all cash flows
• use of discounting reduces the impact of long-term
• has a decision making mechanism - rejects projects with negative NPV

Question 19

Disadvantages of NPV

Answer 19

• complex to calculate
• cannot compare projects with a different initial costs
• rate of discount is critical - if it is high, fewer projects will be profitable