3.3.2 Investment Appraisal

Question 1

What factors should be considered when deciding to go ahead with an investment project?

Answer 1

• Competition.
• Market.
• Returns.
• Financial position.
• Shareholder opinion.
• Does it fit with ethics stance?

Question 2

Investment appraisal techniques

Answer 2

1) Payback
2) Average rate of return
3) NPV

Question 3

Payback

Answer 3

The length of time it takes for an investment to recoup its original cost.

Question 4

Payback formula

Answer 4

Number of full years + (what you need/what you get) x 12

Question 5

Benefits and drawbacks of payback

Answer 5

+ Simple method.
+ Useful for businesses where cash flow management is vital.
+ Compare competing projects.
+Takes into account cost of investment.

• Ignores overall account of project - only considers time to recover investment.
• Ignores time value of money.
• Encourages a short term approach.

Question 6

Average rate of return

Answer 6

An investment appraisal technique which measures the net return per annum as a percentage of initial cost.

Question 7

Average rate of return formula

Answer 7

(Average annual profit/initial cost) x100

Question 8

Advantages and disadvantages of ARR

Answer 8

+ Measures profitability.
+ Compare % returns against other investments.
+ Considers the total profit made.
- Ignores the timings of cash flow.
- Ignores time value of money.
- Risk that projections of future sales may be more inaccurate the further they are.

Question 9

NPV

Answer 9

The present value of future income from an investment appraisal. The value of money is considered.