3.3.2 investment appraisal

Question 1

investment appraisal

Answer 1

process of analysing if investment projects are worthwhile and profitable. for decisions

Question 2

payback period

Answer 2

the shorter the better. the amount of time it takes for a project to repay its initial investment outlay. measured In time e.g. years

Question 3

net cash flow formula

Answer 3

inflows-outflows

Question 4

payback formula`

Answer 4

sum invested/net cash per time

Question 5

steps:

Answer 5

1- work out net cash flow if not already given in-out
2- work out the cumulative net cash flow for each year by adding the next years net cashflow to the initial investment number e.g. -400 + 20…
3- keep going until there are no more negative no.s
4- circle the two years where there’s a + then straight after year that’s -
5- neagive year is amount of years it takes to pay back
6- work out specifically months, do the negative no./ the year afters net cashflow then x by 12

Question 6

+ of pp

Answer 6

• easy to understand the results and calculate as you just need to see how long it takes to get the initial investment back. this means that it will be easier to make quick comparisons for example between different projects pp length.
• it can measure liquidity. this is cuz the quicker the initial investment is paid off, the earlier the generated cash is available for use.
• emphasises speed of return which is good for markets that change rapidly as its important to recover cost of investment for e.g. new models/products.

Question 7

• of pp

Answer 7

• the pp doesn’t take into account cash flows after the pp. cuz it only takes into consideration when the project breaks even and not what happens after that. therefore ignores cash flows after pp calculated. It’s a problem as after pp calculated the b may get huge returns which will be ignored as it ignores numbers after money is recouped.
• doesn’t take into consideration external influences e.g. inflation. cuz pp lacks info and detail as it is designed to only tell when the whole sum of money Is paid back. also lacks detail and info as it ignores qual data which can alter cash flows and therefore no. of years taken to pay back the initial investment.
• doesn’t ACC create a decision for the investment
• takes no account of the time value of money

Question 8

eval for payback

Answer 8

this method may lead to short-termism/ short term thinking as its aim is to only see how fast money is repaid. results in clouded judgement being made. not sustainable or trustworthy.

Question 9

ARR

Answer 9

in percentage, the higher the ARR the better. ftells us how much return an investment will give us annually if we invest. looks at the total accounting return for a project to see if it meets the target return. it compares the average annual profit generated by an investment with the amount of money invested in it.

Question 10

ARR formula

Answer 10

(average net return/no. of project years) / initial investment x100

Question 11

average annual return formula

Answer 11

neturn return (all yrs added together including investment)
average net return= divide this no by years 
divide this no by initial investment

Question 12

next step of ARR

Answer 12

average annual return / initial investment x 100

Question 13

pros of ARR

Answer 13

• Considers total return of the projects. this is cuz we add up all cash inflows in years which payback ignores. therefore looks at the project as a whole, all the returns. as it doesn’t stop when the investment has been paid back. focuses on the overall profitability of an investment project.
• simple and easy to calculate so can understand better by comparing other projects ARR to help make quick decisions.

Question 14

cons of ARR

Answer 14

• doesn’t consider the value of money. this is cuz it doesn’t discount the fact that money in the future may not be as valuable to bs as to have that money right now.
• ignores the timings of returns or payment like payback. this means there is no liquidity focus in ARR unlike payback as you know when you have recouped the initial cost of investment.
• if the data calculated is wrong or inaccurate then the results and therefore the decision made will not be correct. therefore this is a loss for the business. this is cuz it leads to less return being generated and low profit levels than the firm expected.

Question 15

NPV

Answer 15

answer = £. calculates the monetary value now of the projects future cashflows by taking interest rates into account by applying a % to future cashflows to reduce their value to the account for the time value of money. should be accepted if the answer is a positive number. we do this because money in the future is not worth what It is today so we use discount factor to make a more realistic judgement.

Question 16

NPV formula

Answer 16

cashflow x discount factor

Question 17

NPV process

Answer 17

1- multiply net cashflow and discount factor for however many years there are
2- add all the answers to step 1
3- from this no. - the initial investment no.
then / this by initial investment x 100

Question 18

eval for NPV

Answer 18

it depends on the amount invested compared to the NPV numbers as if there’s a big diff between the two (how big the return is) it may not be a good investment. if its not that big

Question 19

pro of NPV

Answer 19

• npv takes inflation and the value of money and time into consideration unlike the other investment appraisal methods which don’t take the value of money in the future into account.
• easier to see whether you should accept or reject a project as you observe whether the npv value is a positive or negative, if positive then accept which is quicker and easier unlike payback

Question 20

con of NPV

Answer 20

• the calculation for this method is very complex espescially compared to the other methods.
• if there is a flaw in the calculated forecasts of future cashflows it will negatively impact the forecast and therefore the decsisons made about persuing that project. this is difficult to be accurate especially as its a complicated calculation
• all the inflows in the future are just estimated like ARR and payback
• the interest rates will change the discount factor. this means if the forecast is wrong on the interest rates then the discount factor will end up wrong which means if this is wrong then the present value will be wrong.

Question 21

eval of NPV

Answer 21

the results also depends on the rate of discount used so the higher the rate, the more likely it is that the project will be rejected as unprofitable