investment appraisal

Question 1

What is investment appraisal?

Answer 1

A technique used to evaluate planned investment and measure its potential value to the business.

Question 2

What are the three main methods of investment appraisal?

Answer 2

• Payback period
• Average Rate of Return (ARR)
• Discounted Cash Flow (DCF)/Net Present Value (NPV)

Question 3

What is the payback period?

Answer 3

The time it takes for an investment to repay its initial cost.

Question 4

How is the payback period calculated?

Answer 4

initial investment/ annual cash flow

Question 5

Give two advantages of using payback period.

Answer 5

• Simple to calculate
• helps manage cash flow.

Question 6

Give two disadvantages of using payback period.

Answer 6

• Ignores profitability after payback
• encourages short-term thinking.
• Ignores total profitability, the focus is just on the speed to which the initial outlay is repaid.

Question 7

What is the Average Rate of Return (ARR)?

Answer 7

Average annual profit as a % of initial investment.

Question 8

How is ARR calculated?

Answer 8

ARR = (Average Annual Return / Initial Outlay) × 100

Question 9

Give two advantages of ARR.

Answer 9

• Uses all cash flows
• Focuses on profitability.

Question 10

Give two disadvantages of ARR.

Answer 10

• Ignores timing of cash flows
• Does not allow for effects of inflation on values of
  future cash flows.

Question 11

What is Discounted Cash Flow (DCF)?

Answer 11

Investment appraisal that considers the time value of money.

Question 12

What is Net Present Value (NPV)?

Answer 12

The present value of future cash inflows minus the initial investment.

Question 13

Why is future money worth less?

Answer 13

• Due to inflation
• opportunity cost of capital.

Question 14

Give the formula to calculate NPV.

Answer 14

NPV = (Cash Flow × Discount Factor) - Initial Investment

Question 15

Give two advantages of using NPV.

Answer 15

• Allows for future earnings to be adjusted to present
  values.
• Easy to compare different projects.
• Allows for impact of inflation

Question 16

Give two disadvantages of using NPV.

Answer 16

• Complex calculation
• estimates may be inaccurate.

Question 17

What qualitative factors might influence investment decisions?

Answer 17

• Fit with business strategy
• staff impact
• economic climate
• competitor actions
• ethics

Question 18

What happens to discount factors over time?

Answer 18

They decrease, reflecting that future money is worth less.

Question 19

How is a discount factor used in NPV calculation?

Answer 19

Each year’s cash flow is multiplied by the discount factor to get its present value.