3.3.2 Investment Appraisal

Question 1

What is investment appraisal?

Answer 1

The planning process used to determine whether the long term investments will give the best return.

Question 2

What must investment decisions balance?

Answer 2

Risk and return

Question 3

What are the 2 main questions firms try to answer to help them make good investment decisions?

Answer 3

1. How long will it take to get back the money that they spend?

2. How much profit will they get from the investment?

Question 4

What are the 3 methods to help answer these questions?

Answer 4

- Simple payback
- Average Rate of Return (ARR)
- Discounted cash flow

Question 5

Define payback period

Answer 5

The time it takes for a project to make enough money to pay back the initial investment

Question 6

How do you calculate payback period?

Answer 6

Amount invested / annual net cash flow

Question 7

Define ARR

Answer 7

Compares the net return with the level of investment

Question 8

Define net return

Answer 8

The income of the project minus the costs

Question 9

How is ARR calculated?

Answer 9

Average net return / investment X 100

Question 10

What are the steps to calculate ARR?

Answer 10

1. Add up all the cash inflows from all years.
2. Minus the original cost of the project.
3. Divide this by the number of years the project runs for.
4. Then divide it by the cost of the project
5. Multiply by 100

Question 11

What is discounted cash flow?

Answer 11

Takes into account the time value of money

Question 12

What is a limitation of simple payback?

Answer 12

Only looks at the speed of payback and not profitability.

Question 13

What is a limitation of ARR?

Answer 13

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

Question 14

What is a limitation of NPV?

Answer 14

Very complex