Investment Appraisal

Question 1

net present value (NPV)

Answer 1

today’s value of the estimated cash flows = from an investment.

Question 2

Investment Appraisal

Answer 2

evaluating the profitability or feasibility of an investment project.

Question 3

When appraising the profitability of investment projects using quantitative techniques, the following information will be required:

Answer 3

• initial capital cost of the investment such as the cost of buildings and equipment
• estimated life expectancy or the ‘useful life’ of an asset
• residual value of the investment – at the end of their useful lives, the assets will be sold, leading to a further cash inflow

Question 4

Forecasted net cash flow

Answer 4

forecast cash inflows less forecast cash outflows.

Question 5

Forecasted net cash flow assumes that:

Answer 5

• cash inflows are the same as the annual revenues earned from the project
• cash outflows are the initial capital cost of the investment and the annual operating costs.

Question 6

quantitative methods of investment appraisal are:

Answer 6

• payback period
• accounting (or average) rate of return.

Question 7

Payback period

Answer 7

length of time it takes for the net cash inflows to pay back the original capital cost of the investment.

Question 8

Why is the payback of a project important?

Answer 8

• Managers can compare the payback period of a particular project with other alternative projects so as to put them in rank order.
• The payback period can be compared with a cut-off time period that the business may have laid down.

Question 9

Advantages of the payback method

Answer 9

• It is quick and easy to calculate.
• The results are easily understood by managers.
• It is particularly useful for businesses where liquidity is of greater significance than overall profitability

Question 10

Disadvantages of the payback method

Answer 10

• on the short term may lead businesses to reject very profitable investments - they take some time to repay the capital.
• does not consider the timing of the cash flows during the payback period

Question 11

Accounting rate of return

Answer 11

measures the annual profitability of an investment as a percentage of the avg. investment (bag capital cost).

Question 12

Why is the ARR of a project important?

Answer 12

It indicates to the business that, on average over the lifespan of the investment, it can expect an annual return of 20% on its investment.

Question 13

Criterion rate

Answer 13

The minimum accounting rate of return that a business would accept before approving an investment.

Question 14

Advantages of ARR

Answer 14

• focuses on profitability, which is the central objective of many business decisions.
• it use all of the cash flows, unlike the payback method.
• results easily understood and easy to compare with other projects that may be competing for the limited investment funds available.

Question 15

Disadvantages of ARR

Answer 15

• Time value of money is ignored as the cash flows have not been discounted.
• ignores the timing of the cash flows. This could result in 2 projects having similar ARR results - one could pay back much quickly than the other.

Question 16

Discounted cash flow

Answer 16

The present- day value of a future cash flow.

Question 17

Net present value NPV

Answer 17

Uses discounted cash flows. It’s calculated by subtracting the capital cost of the investment from the total discounted cash flows.

Question 18

What are the 3 stages in calculating NPV?

Answer 18

• multiply net cash flows by discount factors. Cash flows in year 0 are never discounted, as they are present-day values already.
• add the discounted net cash flows.
• subtract the capital cost to give the NPV.

Question 19

Advantages of NPV

Answer 19

• considers both he timing of cash flows and the size of them in arriving at an appraisal.
• considers the time value of money and takes the opportunity cost of money into account.

Question 20

Disadvantages of NPV

Answer 20

• complex to calculate & explain
• can be compared to other projects but only if the initial cost is the same.

Question 21

Qualitative factors and their impact on investment decisions: