3.7.8 Flashcards
What is investment appraisal?
Investment appraisal is the process of analyzing the financial merits of a potential future investment to determine its profitability and suitability for a business.
What is the payback period in investment appraisal?
The payback period calculates the length of time it will take for a business to recover its initial investment. The shorter the payback period, the less risky the investment.
What does ARR (Average Rate of Return) assess in investment appraisal?
ARR assesses the worth of an investment by calculating the average annual profit as a percentage of the initial investment. A higher ARR indicates a more profitable investment.
What is Net Present Value (NPV), and how is it calculated?
NPV calculates the present value of future cash flows, considering the time value of money. It is calculated by discounting future cash inflows using a discount rate and subtracting the initial investment. A positive NPV suggests a profitable investment.
What are the advantages of using Payback as a method of investment appraisal?
The main advantage of Payback is its simplicity. It helps businesses determine how quickly they can recover their initial investment, reducing risk by focusing on a short time frame for return.
What is a key disadvantage of the Payback method?
A disadvantage of Payback is that it does not take into account the time value of money or cash flows that occur after the payback period, potentially ignoring the full profitability of an investment.
What does a positive NPV indicate?
A positive NPV indicates that the investment is expected to generate more cash than it costs, and therefore it is considered a profitable investment that should be accepted.
Why are non-financial factors important in investment decisions?
Non-financial factors, such as the reliability of cash flow forecasts, the impact on the company’s image, ethical considerations, and stakeholder reactions, should be considered alongside financial data to make well-rounded investment decisions.
What role does sensitivity analysis play in investment appraisal?
Sensitivity analysis helps assess the potential risks and outcomes of an investment by testing how variations in key assumptions (e.g., sales volumes or costs) affect the investment’s profitability. It helps managers understand the risks involved in uncertain situations.
What is an example of a non-financial factor influencing investment decisions?
An example of a non-financial factor could be the potential impact of the investment on the company’s reputation, or ethical considerations like the environmental impact or worker conditions.
How does an investment’s risk and uncertainty affect decision-making?
Risk and uncertainty affect investment decisions because they introduce unknowns. Uncertainty about future costs and revenues can make it more difficult for businesses to predict the returns on investment and assess whether the investment is worthwhile.
What is the importance of investment criteria in decision-making?
Investment criteria are pre-determined targets used to judge an investment’s acceptability. These targets help avoid bias in decision-making and ensure that investments align with the business’s financial and strategic goals.
What are some possible investment criteria that a business may set?
Some possible investment criteria include:
Payback within a set time period
ARR above a certain threshold
Positive NPV with a specified percentage of initial investment
NPV with the shortest payback period
Why is the source and amount of money invested a factor in investment risk?
The source and amount of money invested are crucial because a larger sum or higher risk investment can increase the potential for loss. If the money comes from external sources, such as loans, the risk increases due to the obligation of repayment.
What is the role of the investment appraisal methods in business strategy?
Investment appraisal methods help businesses assess the financial feasibility and risks associated with investments, guiding them to make informed decisions that align with long-term strategic objectives and financial goals.
