3.3.2 Investment Appraisal

Question 1

What does investment appraisal involve?

Answer 1

• Involves comparing the expected future cash flows of an investment with the initial outlay (cost) for that investment

business may want to analyse how soon the investment will recoup the initial outlay or how profitable the investment will be.

Question 2

What are the different methods used to appraise the value of an investment?

Answer 2

• Simple payback period
• Average Rate of Return
• Net present value of discounted cash flow

Question 3

What is the simple payback period?

Answer 3

• A calculation of the amount of time it is expected an investment will take to pay for itself

Question 4

How do you work out payback?

Answer 4

• Work out net cash flow for each year (inflow-outflows)
• Arrange it into a table with the cost of the investment at the top in brackets
• Then working down- work out the cumulative cashflow for each year
• You do this by adding on the net cashflow to the cost of the investment first.
• (This will give you a minus number initially)
• You then keep adding the net cashflow year on year until you have covered the cost of the investment
• It is in this year the payback occurs
• However, it may not fall on a exact year & instead happen during a year
• For this you then need to work out the number of months
• Take the net cash flow of that year divid it by 12
• Then take the amount of money you have left to pay & divide it by this amouny (the monthly cashflow)
• This result will then give you the number of months.

Question 5

What are the benefits and drawbacks of using the payback method?

Answer 5

Benefits:
- Simple method to calculate and understand
- It is particularly useful for businesses where the cashflow management is vital
- Businesses can identify the point at which the investment is paid back & contributing to positive cashflow
- Businesses purchasing equipment can calculate whether an investment ‘pays back’ before an upgrade is available

Drawbacks:
- It provides no insight to the into the profitability of investments
- it may encourage a short-termism approach
- Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives

Question 6

What is the average rate of return?

Answer 6

• AAR compares the average profit per year generated by an investment with the value of an initial outlay

Question 7

What is the formula for average rate of return?

Answer 7

• Average Annual Return (AAR)/ Initial Outlay x100

Question 8

What are the advantages and disadvantages of average rate of return?

Answer 8

Advantages:
- It considers all of the net cash flows generated by an investment over time
- It is easy to understand and compare the % returns with each other

Disadvantages:
- As it depends on average cash flow, it ignores the timings of those cash flows
- The opportunity cost of the investment is ignored as values are nether expressed in real terms nor adjustments made for the impact of interest rates and time

Question 9

What is net present value (NPV)?

Answer 9

• A financial metric used to evaluate the value of an investment or a project
• The NPV of a project takes into account the effects of interest rates and time
• If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile but if it is positive then it is likely to be worthwhile

Question 10

What does NPV represent?

Answer 10

• It represents the present value of the future cash inflows minus the future cash outflows
• To get the present value the future value has to be discounted/ reduced

Question 11

What are the advantages & disadvantages of NPV?

Answer 11

Advantages:
- It considers the opportuity cost of money
- Discount tables are used to calculate forecast future values of net cashflows

Disadvantages:
- It is more complicated to calculate and interpret than other methods of investment appraisal
- One of the primary challenges of using the NPV method is accurately forecasting future cash flows
- The NPV method only considers the financial costs and benefits of a project and does not account for non-financial benefits or costs, e.g. environmental damage

Question 12

What are the limitations of the investment appraisal techniques?

Answer 12

• Each of the investment appraisal techniques relies upon forecasted future cash flows which may lack accuracy
  Managers compiling cash flow forecasts may lack experience or may be biased towards a particular investment

Long-term cash flow forecasts can be inaccurate for several reasons:
- Unexpected increases in costs
- The arrival of new competitors
- Changes in consumer tastes
- Uncertainties due to economic growth or recession