3.3.2 Investment appraisal

Question 1

define investment appraisal

Answer 1

the evaluation of an investment project to determine whether or not it is likely to be worthwhile

Question 2

define average rate of return

Answer 2

a method of investment appraisal that measures the net return per annum as a percentage of the intial spending

Question 3

define capital cost

Answer 3

the amount of money spent when setting up a new venture

Question 4

define discounted cash flow

Answer 4

a method investment appraisal that takes interest rates into account by calculating the present value of future income

Question 5

define investment

Answer 5

the purchase of capital goods

Question 6

define net cash flow

Answer 6

cash inflows - cash outflows

Question 7

define net present value

Answer 7

the present value of future income from an investment project, minus the cost

Question 8

define payback period

Answer 8

the amount of time it takes to recover the cost of an investment project

Question 9

define present value

Answer 9

the value today of a sum of money available in the future

Question 10

what does investment appraisal attempt to determine?

Answer 10

the value of capital expenditure projects, it enables the business and its investors to compare projects -> expansion and meet objectives

Question 11

What is meant by capital expenditure?

Answer 11

Assets which will be used in the long term

Question 12

Is IA used in the planning process, if so what for?

Answer 12

yes
used to determine whether long term investments will give the best monetary return
etc. new machinery, new premises

Question 13

How do we calculate payback periods?

Answer 13

Year 0 is when the investment was made so the value is a minus
1. Add the years of the data to equal the value of the investment
if the value of the return is higher than the investment
-divide the years potential profit by 12 to get how much is made in a month
-divide the amount needed the profit made in a month to get the amount of months needed to payback the full investment

Question 14

give 3 Drawbacks of using simple payback

Answer 14

too simple
cash earnt after the payback period is ignored
The profitability of the method is overlooked as only looks at the speed of payback

Question 15

give 3 advantages of using simple payback

Answer 15

it is simple to use and to interpret
firms can adopt this method if they are experiencing cash flow problems as the project will payback the investment more quickly than others
useful when tech changes rapidly to recover the costs of R&D

Question 16

how should payback be interepted?

Answer 16

• the length of time that money is invested at risk
  -look for shortest payback period

Question 17

What is the formula to work out the ARR?

Answer 17

ARR (%) = Net return per annum/ Capital outlay (cost) X 100

Question 18

what does ARR measure?

Answer 18

the net returns each year as a percentage of the capital cost of the investment

Question 19

what are the steps to work out ARR (walk through for formula)

Answer 19

1. Add up net cashflows
2. Minus cost of project
3. Divide the value by the number of years the project runs over
4. then divide the value by the cost of the project and multiply by 100

Question 20

How should a business interpret ARR rates?

Answer 20

-shows average profit made each year based on the investment
- businesses should look for the highest percentage of return

Question 21

What is a disadvantage of ARR?

Answer 21

doesn’t take into account the effects of time on the value of money

Question 22

what are some advantages of using ARR?

Answer 22

clearly shows the profitability of a project
allows a range of products to be compared
easy to identify the opportunity cost

Question 23

what does Net present value account for?

Answer 23

what the cashflow or profit earned in the future is worth at the present value

Question 24

how to calculate net present value?

Answer 24

1st calculate the present value by multiplying the net cash flow by the discount rate
2nd add all the present values to give the net present values and then minus the initial cost

Question 25

how should NPV be interpreted?

Answer 25

-Shows how much profit is made in the future is really worth in todays terms
-Businesses should choose the highest NPV

Question 26

give 3 drawbacks of NPV

Answer 26

too complex
not used by small businesses
the rate of discount is critical-if high then fewer projects will be profitable (inflation also isnt accounted for)

Question 27

give 2 advantages of using NPV

Answer 27

it correctly accounts for future earnings by calculating present values
the discount used can be changed as risk & market conditions change

Question 28

what are some qualitative factors which will affect business choices?

Answer 28

-Human relations -> if choice could affect staff then may postpone plans
-Ethical consideration
-Risk ->the financial position the business is in, the state of the economy and the markets involved
-Availability of funds -> small business may struggle to raise investors and lendors
-Business confidence -> risk takers or shy managers?