Capital Investment Appraisal

Question 1

What is capital investment appraisal

Answer 1

A tool that enables a business to make decisions as to whether or not to invest in a particular capital investment project and, where there are alternatives, to assist in deciding in which to invest

Question 2

What is payback period

Answer 2

How quickly a company takes to recoup its initial outlay. Payback is concerned with cashflows only - non cash items like depreciation are ignored

Question 3

Give 3 advantages of payback period

Answer 3

• Easy to calculate
• Easy to understand
• Places more emphasis on earlier cash flows, which are likely to be more accurate
• Ideal for high technology projects

Question 4

Give 3 disadvantages of payback period

Answer 4

• Total profitability of the project is ignored
• All cash flows after the payback period are ignored
• It doesn’t take into account the timing of cash flows
• inflation ignored
• estimates could be inaccurate
• useful life of capital is ignored

Question 5

What is Net Present Value

Answer 5

Method which recognises that money has a time value

*any project with a positive NPV will add to the value of the business and so increase cash flows

Question 6

Give 3 advantages of Net Present Value

Answer 6

• Relatively easy to understand
• The timing of cash flows is taken into account
• Greater importance is given to earlier cash flows

Question 7

Give 3 disadvantages of Net Present Value

Answer 7

• inflows and outflows are difficult to predict
• the cost of capital may change over the life of the project
• the life of the project is difficult to predict
• figures can be manipulated with discount rates

Question 8

Give 3 financial factors a business should consider when assessing whether an capital investment project is viable

Answer 8

• Source of finance
• Cost of capital
• Estimated cost of project
• Tax implications
• Working capital requirements
• Audit of project

Question 9

Give 3 non-financial factors a business should consider when assessing whether an capital investment project is viable

Answer 9

• Economic climate
• Political implications
• Training
• Capacity
• Product life cycle

Question 10

Evaluate the proposed investment and financing method and advise the directors whether they should proceed with the proposal

Answer 10

Introduction
- State the importance of capital investment appraisal.
- Briefly outline the project being considered.
- Mention the criteria that will be used in the evaluation

Arguments for investing
- NVP positive or negative
- is payback period within estimated project life
- non-financial factors

Arguments against investing
- NVP positive or negative
- is payback period within estimated project life
- non-financial factors
- how big is NPV in compared to initial investment

Analysis of proposed financial method
- gearing ratio
- if shares being used = no need to pay back shareholders but dividends
- is bank loan repayable before payback period
- interest on bank loan will decrease profitability

other factors to consider/evaluate
- use case study
- training costs?
- reliability of data - cash flows only estimates; further out they are, higher risk of inaccuracies

Overall
- alternative source of finance?
- Is the investment in line with the company’s objectives/ethical stance? Market place it operates in?
- decision

Question 11

Evaluate the two developments and advise the directors which one should be selected

Consider both financial and non-financial factors

Answer 11

introduction
- State the importance of capital investment appraisal
- Briefly outline the two developments being considered
- Mention the criteria that will be used in the evaluation

Development 1 Analysis
- Apply NPV, payback period, and profitability index
- Discuss any qualitative factors (e.g., market trends, sustainability)
- Consider risks involved (financial, operational, external factors)

Development 2 Analysis
- Apply NPV, payback period, and profitability index
- Discuss any qualitative factors (e.g., market trends, sustainability)
- Consider risks involved (financial, operational, external factors)
- Highlight key differences between the two developments

Comparative Evaluation
- Directly compare the 2 options using financial & non-financial factors
- Address uncertainties (e.g., economic conditions, market volatility)
- Discuss strategic fit with the company’s long-term objs

Advice & Conclusion
- Based on the analysis, recommend one development w/ justification
- Reinforce why the chosen option is preferable
- Address any limitations in the evaluation