3.3.2 Investment appraisal

Question 1

What are the methods of investment appraisal?

Answer 1

1) Payback
2) Average rate of return
3) Net present value

Question 2

What is payback?

Answer 2

A method of measuring how quickly the cost of the investment can be recouped

Question 3

What is year 0?

Answer 3

The year of initial investment

Question 4

How do you work out payback?

Answer 4

By acknowledging the initial investment then calculate how long it takes to get the investment back.

Question 5

How should you leave the answer for payback?

Answer 5

1) a.b years

2) a years and b months

Question 6

How should you work out the number of months?

Answer 6

multiply the decimal by 12.

Question 7

How should you round your answer?

Answer 7

round the decimal to the next month

Question 8

What is important to remember about investment appraisal techniques?

Answer 8

You should never make a decision based on payback method

Question 9

What does investment appraisal do?

Answer 9

minimises risk

Question 10

What type of capital can be shown in a table for investment appraisal?

Answer 10

1) inflows and outflows

2) net cash flow

Question 11

What are the positives and negatives of using payback?

Answer 11

+ quick and simple, appropriate when liquidity issues arise (debts paid back), valuable assessment on risk
- predicted figures, short-termist, can’t look far into the future and the long-term, doesn’ t take into account the changes in the value of money.

Question 12

What is average rate of return?

Answer 12

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

Question 13

What is the desired payback?

Answer 13

the quicker the payback period the better

Question 14

What is the desired average rate of return?

Answer 14

the higher the figure the better

Question 15

How do you work out average rate of return?

Answer 15

(average rate of return/initial outlay) x 100

Question 16

How do you work out annual profit?

Answer 16

(calculate total net over years - initial investment) / number of years

Question 17

What do you do once you have calculated the investment appraisal value?

Answer 17

compare it with the targets?

Question 18

What are the positives of using average rate of return as a decision-making tool?

Answer 18

forecasts future returns, simple and quick, minimises risk, easy to compare with other methods of investment appraisal

Question 19

What can you easily compare average rate of return to?

Answer 19

interest rates in banks

Question 20

What are the negatives of using average rate of return as a decision-making tool?

Answer 20

only a prediction, doesn’t take into account external factors, doesn’t adjust for time-value of money

Question 21

What is net present value?

Answer 21

a method of investment appraisal that takes into account the value of money over time using a discounted cash flow.

Question 22

Why is important to take into account the value of money over time?

Answer 22

Because a fixed sum paid in the future is less than a fixed sum today. Therefore, this minimises risk.

Question 23

How do you work out net present value?

Answer 23

1) Multiply cash flow figure by the discount factor
2) = discounted cash flow
3) add up all discounted cash flow
4) - initial cost of investment
5) = NPV

Question 24

What does the net present value need to be in order to be viable?

Answer 24

positive

Question 25

What does the net present value need to be for a bad investment?

Answer 25

negative

Question 26

What is the discount factor based on?

Answer 26

inflation rates (if high = high discount factor)