10. Investment Appraisal

Question 1

<p>How is Average Rate of Return or Accounting Rate of Return (ARR) defined?</p>

Answer 1

<p>A method of investment appraisal that measures the net return per annum as a percentage of the initial spending.</p>

Question 2

<p>How is Capital Cost defined?</p>

Answer 2

<p>The amount of money spent when setting up a new venture.</p>

Question 3

<p>How is Discounted Cash Flow (DCF) defined?</p>

Answer 3

<p>A method of investment appraisal that takes interest rates into account by calculating the present value of future income.</p>

Question 4

<p>How is Investment defined?</p>

Answer 4

<p>The purchase of capital goods.</p>

Question 5

<p>How is Investment Appraisal defined?</p>

Answer 5

<p>The evaluation of an investment project to determine whether or not it is likely to be worthwhile.</p>

Question 6

<p>How is Net Cash Flow defined?</p>

Answer 6

<p>Cash inflows minus cash outflows.</p>

Question 7

<p>How is Net Present Value (NPV) defined?</p>

Answer 7

<p>The present value of future income from an investment project, minus the cost.</p>

Question 8

<p>How is Payback Period defined?</p>

Answer 8

<p>The amount of time it takes to recover the cost of an investment project.</p>

Question 9

<p>How is Present Value defined?</p>

Answer 9

<p>The value today of a sum of money available in the future.</p>

Question 10

<p>What is Investment?</p>

Answer 10

<p>Investment or Capital Investment describes the process of purchasing fixed assets, such as new buildings, plant, machinery and office equipment. It refers to the purchase of any asset which the business plans to own, and will pay for itself, over a period of more than 1 year.
<br></br>
<br></br>This may include:
<br></br>- Replacement or renewing existing assets that have worn out (depreciated) or become obsolete
<br></br>- Introduce new assets to meet changes in demand</p>

Question 11

<p>What is Investment Appraisal?</p>

Answer 11

<p>- describes how a business might objectively evaluate an investment project to determine whether or not it is likely to be profitable
<br></br>- It also allows businesses to make comparisons between different investment projects
<br></br>- There are several quantitative methods that a business might use when evaluating a project
<br></br>- However, they all involve comparing the capital cost of the project with the net cash flow</p>

Question 12

<p>What is the Payback Method?</p>

Answer 12

<p>the payback period refers to the amount of time it takes for a project to recover or pay back the initial outlay.
<br></br>- The payback period can also be found by calculating the Cumulative Net Flow.
<br></br>- it is a measure of time, ie days, weeks or years</p>

Question 13

<p>What are the Strengths to the Payback Methods?</p>

Answer 13

<p>There are certain advantages to a business of the use the payback method to appraise the potential success of an investment
<br></br>- This method is useful when technology changes rapidly as it is important to recover the cost of investment before a new model or equipment is designed.
<br></br>- It is simple to use
<br></br>-Firms might adopt this method if they have cash-flow problems. This is because the project chosen will 'payback' the investment more quickly than other
<br></br>- Emphasises cash flow requirements - help planning</p>

Question 14

<p>What is Average Rate of Return (ARR)?</p>

Answer 14

<p>- This method measure the net return each year as a percentage of the capital cost of the investment
<br></br>- Firms want to achieve as high a percentage as possible, certainly higher than they could achieve by keeping the assets invested in a bank as cash.</p>

Question 15

<p>How do you calculate Average Rate of Return?</p>

Answer 15

<p>(Net return (profit)) / ((initial cost) x (time)) x 100
<br></br>- If the ARR is greater than the return available investment markets, ie cash or giving debentures, then its worth it</p>

Question 16

<p>What are the strengths of Average Rate of Return (ARR)?</p>

Answer 16

<p>- it clearly shows the profitability of an investment project
<br></br>- Not only does it allow a range of projects to be compared, the overall rate of return can be compared to other uses for investment funds.
<br></br>- % result makes it easy to compare against other investment choices
<br></br>- Can show true profitability as takes account of all expenditure at face value
<br></br>- % terms are easily understood by non accountants</p>

Question 17

<p>What is Net Present Value (NPV)?</p>

Answer 17

<p>- Money in the future is worth less than the same amount now (the present value )
<br></br>- This is because money available today could be invested and it could earn interest
<br></br>- Note that is a completely different idea to the fact that money in the future can also because devalued due to the effects of inflation
<br></br>- Discounted Cash -flow techniques just deal with one of these, the effect of interest rates</p>

Question 18

<p>What is Discount Cash Flow?</p>

Answer 18

<p>- The payback and ARR methods assume the timing of payments and receipts are not important, they ignore the time value of money
<br></br>- As such, any payment you receive in the future are discounted (reduced) to reflect their lower future value.
<br></br>- in essence, it is taking a discount rate of the investment now and adding the total present values together to give you the total return on investment
<br></br>- the higher the rate of discount the less the present value of cash flow in the furture</p>

Question 19

<p>How do you calculate Discounted Cash Flow?</p>

Answer 19

<p>- take the discount rate. starting at 1 each year after divide by the discount rate
<br></br>- multiple each year's total revenue by their relevant discount factor to give you the present value
<br></br>- total the present values to give you the net present value
<br></br>- take the net present value and take away the initial cost to give you the value</p>

Question 20

<p>What are the strengths of Discounted Cash flow?</p>

Answer 20

<p>- Only method that considers time value of money
<br></br>- As future monies are discounted heavily, less risk if incorrect
<br></br>- Only system to give precise answer</p>

Question 21

<p>What are the weaknesses of the Payback method?</p>

Answer 21

<p>- Calculation ignores revenues or costs that occur after point of payback
<br></br>- Estimates over long periods can be inaccurate
<br></br>- Takes no account of the future value of money
<br></br>- Long payback terms may put off investment, leading to short-termism</p>

Question 22

<p>What are the weaknesses of the Average Rate of Return?</p>

Answer 22

<p>- Harder and more time consuming to calculate.
<br></br>-Takes no account of the future value of money</p>

Question 23

<p>What are the weaknesses of Discount Cash flow?</p>

Answer 23

<p>- Time consuming and difficult to calculate
<br></br>- Difficult to understand, particularly for non financially trained
<br></br>- Flat discount rate is unrealistic.</p>

Question 24

<p>How do companies account for risk?</p>

Answer 24

<p>Firms take the following actions to allow for the risks and uncertainties:
<br></br>- Build in contingencies – allow extra funds to account for changes in costs so that would make the project run over budget.
<br></br>- Calculate alternative scenarios – expected, best and worst case scenarios
<br></br>- Set demanding targets – high ARR’s or short payback terms. Covering costs early removes future uncertainties.</p>

Question 25

<p>What Qualitative Factors may influence a Investment decisions?</p>

Answer 25

<ol><li><span><strong>Human relations.</strong>Some investment projects can have a huge impact on the staff in anorganisation. For example, investment in plantautomation (i.e. replacing workers with machines)might lead to mass redundancies. A business might decide to postpone plans to automate theirplant if it thought the damage to human relationsin the organisation would be too severe.</span></li><li><span><strong>Ethical considerations.</strong>Along with many other business decisions, managers are being moreethical (i.e. thinking about what is right and wrong)when choosing courses of action. For example, achemicals producer might decide to build a newplant in a location that does not minimise financialcosts but does reduce environmental damage. This decision might help to further improve theimage of a company. Companies are increasinglykeen to be seen as 'good corporate citizens'.</span></li><li><span><strong>Risk.</strong>One factor in assessing the risk of aninvestment project is a business's financialsituation. Other factors include the state of the economy and the markets into which a businesssells. Investment projects that have long paybackperiods are also riskier than ones with shorterpayback periods.</span></li><li><span><strong>Availability of funds.</strong>Some investment projectsdo not start because businesses are unable toraise the money needed to fund the project. Alarge number of these will be small businessesthat find it difficult to persuade investors andlenders to provide finance.</span></li><li><span><strong>Business confidence.</strong>Entrepreneurs, managersand businesses tend to have different attitudesand cultures to each other. One aspect of this isconfidence or optimism (i.e. a feeling that goodthings will happen). Some decision makers tendto be very cautious, seeing all the problems thatmight arise if things go wrong. Some decisionmakers are confident and optimistic. They see thefuture as much better and brighter than others.This has a crucial impact on investment. The cautious, unconfident entrepreneur or managermay delay or abandon investment projects. In thesame circumstances with the same investmentprojects, confident and optimistic managers will tend to go ahead and authorise the expenditure.So, the deeply held attitudes of decision makershave an important influence on investmentdecision making.</span></li></ol>