Investment Appraisal

Question 1

What are the three methods of investment appraisal

Answer 1

1) Payback period
2) Average rate of return
3) Discounted cash flow

Question 2

What’s payback period

Answer 2

The time it takes for a project to make enough money to pay back the initial investment

Question 3

If project has a consistent annual net cash flow then what formula do you use

Answer 3

Amount invested / Annual net cash flow

Question 4

If a business doesn’t have consistent annual net cash flow, what formula is used

Answer 4

Amount required / net cash flow in that year X12

Question 5

How to work out payback period

Answer 5

• Add the cash flows of each year until you match the investment
• If the next year doesn’t match the amount needed, you use the formula amount needed / amount in that year X12

Question 8

What’s the formula for annual net cash flow

Answer 8

Money the project will generate each year minus how much it will cost each year

Question 9

What do managers want with payback periods

Answer 9

Managers usually want their money back as soon as possible, so they prefer a short payback period

Question 10

What does average rate of return do

Answer 10

Compares the net return with the level of investment.

Net return is income of the project minus costs, including the investment

Question 11

Is it better for ARR to be higher or lower

Answer 11

The higher the ARR, the more favourable the project will appear

Question 12

Formula for ARR

Answer 12

Average net of return / investment X100

Question 13

How to work out ARR

Answer 13

• Add net cash flow up from each year
• Minus the investment from the total
• Then divide it by amount of years which gives you average net return
• Then do average net return / investment X100

Question 14

What’s discounted cash flow

Answer 14

Investment appraisal tool that takes into account the time value of money

Question 15

What does discount scores depend on

Answer 15

Interest rates

Question 16

What happens if you get a negative NPV

What happens if you get a positive NPV

Answer 16

Negative NPV= Business could get a better return by putting their money into a savings account rather than going ahead with the project

Positive NPV= Project will make them money (get a profit)

Question 17

How do you work out NPV

Answer 17

• Do net cash flow x discount factor for each year
• Add the answers for each year to get a total present value of net cash flows
• Then minus the investment from the value you get from adding the sum of each year
• Then the number you get, you divide that by the investment and X100

Question 18

Advantages and disadvantages of payback period

Answer 18

Advantages= -Easy to calculate and understand
- Good for projects that might not provide long-term returns

Disadvantages= -Ignores cash flow after payback. (Project A continue to provide a return of £20,000 a year, project B won’t provide any more return)
-Ignores time value of money

Question 19

Advantages and disadvantages of ARR

Answer 19

Advantages= -Easy to calculate and understand
-Takes account of all the projects cash flows. E.g. doesn’t stop counting cash flow after a certain point, like payback period does

Disadvantages= -Ignores timing of cash flows. (E.g. a firm might put more value on money that they get sooner rather than later)
-Ignores time value of money

Question 20

Advantages and disadvantages of NPV

Answer 20

Advantages= -Takes into account time value of money
-More accurate

Disadvantages= -Hard to calculate
-Difficult to work out the discount factor as they don’t know the interest rates in the future