3.3.2. Investment Appraisal

Question 1

Investment appraisal

Answer 1

Process of using forecast cash flows to assess the financial attractiveness of an investment decision, linked with a consideration of non-financial factors.

Comparing expected future cash flows of an investment with initial outlay for that investment the initial outlay for that investment

-Pay back period
-Av. ROR
-Net present value

Question 2

Pay back period

Answer 2

Time taken for project to repay its initial investments.
1.Identify Net Cash Flow for each period
2.Keep running total of cash flows
3.Initial investments=outflow
Previous year+ (CCF of prev. Yr/CF of Yr payback occurred)

Question 3

Av. Rate of return

Answer 3

Looks at tot. accounting return for a project to see if it meets target return. annual % return on investment project based on av. returns earned.
1.Calculate av. annual profit from investment project
2.Divide av. annual profit by initial investment, X100
3.Compare with target % return

Make sure to deduct initial investment in step 1.

Question 4

+ves and -ves of ARR

Answer 4

+ves:
-simple to understand and easy to calculate
-focuses on overall profitability of investment project
-considers cash flow over projects entire lifetime
-easy to compare to other measures of returns

-ves:
-ignores timings of returns
-focuses on profits rather than cash flows
-doesn’t adjust for the time value of money.
-including forecasts from far in future may reduce reliability of forecasts

Question 5

Discounted cash flow(NPV)

Answer 5

NPV calculates monetary value now of the projects future values.£
Discounting-method to reduce future value of cash flows to reflect risk that it may not happen. Better to receive cash now than on future as future cash can depreciate and be worth less.
Money tied up in an investments has an opportunity cost.

Present value= cash flow x discount factor
NPV= add all present values of future cash flows
Accept project if NPV is +ve.

Question 6

+ves and -ves of pay back return

Answer 6

+ves:
Easy to calculate and understand
Takes into account timing of cash flow
More accurate as it ignores longer term forecasts which may make it less accurate.

-ves:
Doesn’t look at overall returns
Doesn’t adjust for time value of money
Tells us nothing about profitability

Question 7

+ves and -ves of NPV

Answer 7

+ves:
Takes opportunity cost of money into account
One calculation which considers both amount and timing of cash flows to indicate profitability

-ves:
Complex to calculate and communicate
Can be misunderstood
Only comparable between different projects if initial investments are the same

Question 8

Other factors affecting investment decisions

Answer 8

1.Corporate objectives-does chosen investment focus on achieving agreed objectives

2.Company finances-Extensive investments may place firms finances at risk if they require external finances.

3.Confidence in data-consider accuracy of forecasts

4.Social responsibilities-If investment helps meet businesses social responsibilities, some may be willing to proceed even if it isn’t most financial attractive option.

Question 9

Risk

Answer 9

Great uncertainty attached to cash flow forecasts
Should ideally avoid investing in any project that it cannot afford to lose initial investment