3.3.2 investment appraisal

Question 1

payback concept links

Answer 1

cash flow
investment
risk and return
NPV
ARR

Question 2

define investment appraisal

Answer 2

process of analysing whether investment projects are worthwhile

Question 3

main methods of investment appraisal

Answer 3

payback period
average rate of return
discounted cash flow NPV

Question 4

payback period

Answer 4

time it takes for a project to repay its initial investment

Question 5

average rate of return

Answer 5

looks at the total accounting return for a project to see if it meets the target return

Question 6

discounted cash flow NPV

Answer 6

calculates the monetary value now of the projects future cash flows

Question 7

define payback period

Answer 7

the time it takes for a project to repay its initial investment

Question 8

calculating payback

Answer 8

identify the net cash flows for each period - year
keep a running total of the cash flows
initial investment = an outflow
when does the running total move from negative to positive?
when the total net cash flow becomes positive, payback period ends

Question 9

calculating precise payback period

Answer 9

example:
3 years + part of the 4th year when payback was achieved.
3 + £75,000 / £150,000 = 3.5 years

Question 10

benefits of payback period

Answer 10

simple and easy to calculate.
easy to understand the results.
focuses on cash flows.
emphasis speed of return.
straightforward to compare competing projects

Question 11

drawbacks of payback period

Answer 11

ignores cash flows after payback has been reached.
takes no account of the time value of money.
may encourage short term thinking.
ignores qualitative aspects of a decision.
does not actually create a decision for the investment

Question 12

define annual average return

Answer 12

the annual percentage return on an investment project based on average returns earned by the projects

Question 13

how to calculate ARR

Answer 13

calculate the average annual profit from the investment project.
divide the average annual profit by the initial investment.
compare with the target percentage return

Question 14

benefits of using ARR

Answer 14

simple to understand and easy to calculate.
focuses on the overall profitability of an investment project.
easy to compare ARR with other key target rates of return to help make a decision.
uses all the returns generated by a project.

Question 15

drawbacks of using ARR

Answer 15

ignores the timing of returns
focuses on profits rather than cash flows.
does not adjust for the time-value of money

Question 16

define net present value

Answer 16

calculates the monetary value now of a projects future cash flows

Question 17

define discounting

Answer 17

the method used to reduce the future value of cash flows to reflect the risk that they may not happen

Question 18

the time value of money

Answer 18

better to receive cash now rather than in the future.
future cash flows are worth less.
use discount factors to bring cash flows back to their present value.
relevant discount factor determined by required rate of return.

Question 19

calculating the present value of a future cash flow

Answer 19

cash flow x discount factor = present value

Question 20

the npv decision

Answer 20

accept the project = positive npv
reject the project = negative npv

Question 21

benefits of using npv

Answer 21

considers all future cash flows.
reflects the risks that future cash flows will not be as expected.
different levels of risk can be accounted for by adjusting the discount rate.
creates a straightforward decision - positive npv suggests project should go ahead

Question 22

drawbacks of using npv

Answer 22

the most complicated method compared with payback and ARR.
choosing the discount rate is hard, particularly for long projects.
result can be influenced / manipulated using the discount rate