Investment appraisal (kill me£

Question 1

what is payback?

Answer 1

a method of investment appraisal tell us how long it takes for a project to payback its initial cost

Question 2

advantages of payback

Answer 2

• good for firms experiencing liquidity problems as it emphasises speed of returns
• simple and quick to calculate
• reduces risk by favouring projects with shorter payback periods
• useful for screening/initial filtering of projects before deeper analysis using more complexmethods

Question 3

disadvantages of payback

Answer 3

• ignores total profitability and focus on the repayment period
• ignores cashflow after payback
• no consideration for time value of money eg money loses value over time
• arbitrary cut off point eg max payback time may cut off beneficial projects
• can encourage short term thinking eg managers to prefer quicker returns at the expense of long term value

Question 4

what is the ARR method

Answer 4

stands for the average rate of return
- assesses the avg annual return of a project as a percentage of the initial investment

Question 5

what is the equation for ARR

Answer 5

avg annual profit
————————— x100
initial investment

Question 6

advantages of ARR

Answer 6

• easy to understand and calculate
• unlike payback, it considers the total profit over the life of a project
• allows for comparison with other targets
• uses figures that are already available in a business financial statement thus being efficient

Question 7

disadvantages of ARR

Answer 7

• ignores the time value of money eg treats all profits equally
• relies on accounting profit, not cash flow giving a misleading view of the projects actual cash generating ability
• ignores timing of returns, giving an avg return and not an actual time

Question 8

what is NPV

Answer 8

stands for net present value
- calculates the total value of future cash flows, discounted to reflect their value today, minus the initial investment

Question 9

advantages of NPV

Answer 9

• Takes time value of money into account
• Considers all cash flows – not just the first few years like Payback.
• Shows actual financial value added – tells you how much profit a project will generate in today’s money.
• Helps compare projects especially useful when comparing options with different lifespans or cash flow patterns.
• Focuses on objectives – supports the goal of increasing shareholder value and long-term profitability.

Question 10

disadvantages

Answer 10

• Can be difficult to calculate without a calculator or spreadsheet
• Requires an accurate choice of discount rate, which can be hard to estimate
• May be less useful if future cash flows are uncertain or unreliable
• Not always easy to explain to people without financial knowledge
• Can give misleading results if assumptions change (like inflation or market conditions)