3.3.2 investment appraisal

Question 1

investment is

Answer 1

Investment is the process of using money with a view to future profit or material gain

Question 2

Investment appraisal is …..

and is used to

Answer 2

Investment appraisal is the use of numerical techniques to predict the financial outcomes of potential capital investments

Investment appraisal may be used to compare different options e.g. location A or location B and/or against predetermined criteria

Question 3

Financial methods of assessing an investment include

Answer 3

Payback
Average (Accounting) rate of return
Discounted cash flow - Net present value

Question 4

what does payback calculate

Answer 4

Calculates how long it will take to pay back the cost of the initial investment
It shows how many years and months

Question 5

how do you calculate payback

Answer 5

Step 1: Calculate during which year the investment cost will be covered
-add up cumulative net cash flow till it reaches the amount of the initial investment , this will give you the year but not the month

Step 2 : Calculate how many months
how much needs to be paid in the next year/ how much had been paid x 12 months

Question 6

describe the payback period

Answer 6

The longer the payback period the greater the degree of risk and uncertainty
Need to also consider how the investment is being funded e.g. if via a bank loan what will the impact be on gearing
Does not take into account what happens after payback
Assumes that in the year of payback that the cash inflow is equal each month

Question 7

Average (accounting) Rate of Return calculates

Answer 7

Calculates average profit as a percentage of the cost of the initial investment

Question 8

how to calculate Average (accounting) Rate of Return

Answer 8

Step 1: calculate average annual profit
Total net cash flow / number of years

Step 2: calculate ARR
Divide average annual profit by initial investment x 100

Question 9

describe what Average (accounting) Rate of Return means

Answer 9

Allows for easy comparison with other forms of investment
The higher the ARR the better the proposed investment
However there is no consideration given to the timings of the inflow

Question 10

Discounted cash flow - Net Present Value calculates

Answer 10

Calculates the total return on an investment taking into account the time value of money

Question 11

how to calculate Discounted cash flow - Net Present Value

Answer 11

Step 1 : Multiply each net cash inflow by the relevant discount factor

Step 2 : add up all the annual NPVs to calculate the total return on the investment

Question 12

describe Discounted cash flow - Net Present Value

Answer 12

A positive NPV implies a worth while investment
But is it a big enough return to justify the risk?
Takes into account the time value of money but the discount factor is a prediction

Question 13

describe Investment Criteria

Answer 13

A predetermined set of guidelines against which an investment can be judged
Minimum targets expected from investments
Will partly depend upon culture
May be influenced by the level of confidence in the predicted figures

Question 14

Investment appraisal is trying to minimise risk or help inform decision making
Key considerations in assessing the degree of risk or uncertainty are:

Answer 14

Gearing
Stability
Opportunity cost
Predictions
Competitor reactions
Time frame

Question 15

Qualitative factors influencing investment decisions

-Stakeholders and external factors

Answer 15

Suppliers
Shareholders
Community
Employees
Management
Environment
Customers