Investment Appraisal

Question 1

Define Investment Appraisal

Answer 1

Evaluating the profitability or feasability of an investment project

Question 2

Define Net Present Value [NPV]

Answer 2

Todays value of the estimated cash flows resulting from an investment

Question 3

Define Payback Period and how is it calculated?

Answer 3

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

Formula: Net cash flow needed / Annual cash flow in year 3 * 12

Question 4

What is the importance of Payback Period as a method of Investment Appraisal?

Answer 4

1. It can aid risk averse managers
2. It can help assess the real value of cash flows by an estimated date
3. It can help assess the certainty of the project [longer the payback, more risky]
4. It can assess how long capital employed is repaid [oppurtunity costs]

Question 5

What are the advantages of using Payback Period?

Answer 5

1. The process can be used to choose the best projects with higher returns
2. Useful for businesses who consider liquidity important over profitability

Question 6

What are the disadvantages of the Payback Period?

Answer 6

1. It does not consider the timing of the cash flows during the payback period

Question 7

Evaluate Payback Period

Answer 7

1. It does not calculate the overall profitability of the project which could alter business decisions - what if a project results profitable in the future but was rejected due to the high capital investment?
2. It is quick and easy to calculate, which can make it simple for managers to utilise

Question 8

What is the Accounting Rate of Return [ARR] and how is it calculated?

Answer 8

It measures the annual profitability of an investment as a percentage of the average capital cost

Formula : Average Annual Profit / Average Investment * 100

Question 9

How is Average Investment Calculated?

Answer 9

Initial Capital Cost + Residual Capital Value / 2

Question 10

What are the advantages of using ARR?

Answer 10

1. It focuses on profitability which aids business objectives
2. It can be compared with other projects that may be competing for investment with limited funds available
3. It can be measured against the criterion rate [minimum accounting rate of return]

Question 11

What are the disadvantages of ARR?

Answer 11

1. Although all cash flows are included, the later cash flows could be inaccurate figures
2. Time value of money is ignored as discount factors are not applied
3. It ignores the timing of the cash flows, which could create similar ARRs between projects, but one could payback quicker

Question 12

What are the advantages of using NPV?

Answer 12

1. The rate of discount can be varied as per different economic conditions, for example, increased if there an expected rise in interest rates
2. It considers the time value of money and accounts for oppurtunity costs
3. It considers the timing of the cash flows

Question 13

What are the disadvantages of NPV?

Answer 13

1. It can be complex to calculate and difficult to explain to some managers
2. The final results depend on the discount factors, which could be misleading
3. It can only be compared with investment projects that have the same capital costs, because it does not provide a % rate of return

Question 14

What are some Evaluation Points to consider about NPV

Answer 14

1. Misleading Discount Rates
2. Reliability of Forecasts
3. Qualitative Factors
4. Comparisons with other methods

Question 15

What are the qualitative factors a business should consider in an investment appraisal?

Answer 15

1. Impact on the environment / local community [CSR, pressure groups if projects take place in sensitive areas]
2. Managers attitude to risk
3. Objectives of the business
4. Impact on the workforce
5. Planning permissions from local authorities