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Business > 3.7.8 Analysing strategic options: investment appraisal > Flashcards

3.7.8 Analysing strategic options: investment appraisal Flashcards

1
Q

What is investment appraisals?

A

The process of analysing whether investment projects are worthwhile.

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2
Q

What are the three financial methods of assessing investment?

A
  • Payback
  • Average rate of return (ARR)
  • Net present balue (NPV)
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3
Q

Why should businesses invest?

A
  • Investment is the process of purchasing non- current assets (building)
  • Investment considers the buying of an asset that will pay for itself over a period of more than one year
  • It replaces ad renews assets and to introduce additional assets
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4
Q

What is payback?

A

The length of time it takes for an investment to recover the initial expenditure.

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5
Q

What is the formula for payback?

A

Amount invested / Annual net return

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6
Q

What does payback focus on?

A

Cash flow and looks at cumulative cash flow of the investment until it has been recouped.

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7
Q

What are the advantages of payback?

A
  • Simple and easy to calculate, and easy to understand the results
  • Focuses on cash flow- good when cash is a scarce resource
  • Straightforward to compare competing projects
  • Emphasises speed of return- appropriate for significant market change
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8
Q

What are the disadvantages of payback?

A
  • Ignores cash flow which arise after payback has been reached
  • Takes no account of the time value of money
  • May encourage short-term thinking
  • Ignores qualitative aspects of decisions
  • Does not actually create a decision for the investment
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9
Q

What is ARR?

A

The total net returns divided by the expected lifetime of the investment, expressed as a % of the initial cost of investment

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10
Q

What does ARR focus on?

A

It looks at the toal accounting return for a project to see if it meets the target return.

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11
Q

What is the formula for ARR?

A

((Total net profit / no Years) / Initial cost ) X 100

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12
Q

What are the advantages of ARR?

A
  • Provides percentage return which can be compared with a target return
  • ARR looks at the whole profitability of the project
  • Focuses on profitability- a key issue for shareholders
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13
Q

What are the disadvantages of ARR?

A
  • Does not take into account cash flows- only profit
  • Takes no account to the time value of money- inflation
  • Treats profits arising late in the project in the same way as those which might arise early
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14
Q

What is a net present value (NPV)?

A

Compares the amount invested today to the present vaue of the further cash receipts from the investment.

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15
Q

What does NPV reflect?

A

Reflects the time value of money by discounting the value of future cash flow

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16
Q

What is the formula for NPV?

A
17
Q

What are the advantages of NPV?

A
  • Takes account of time value money, placing emphasis on earlier cash flows
  • Looks at all the cash flows invloved through the life of the project
  • Use of discounting reduces the impact of long-term, less likely cash flow
  • Has a decision-making mechanism- rejects projects with negative NPV
18
Q

What are the disadvantages of NPV?

A
  • More complicated method- hard to understand
  • Difficult to select the most appropriate discount rate- may lead to good projects rejected
  • NPV calculation is sensitive to initial investment cost
19
Q

Factors influencing investment decisions

What factors affect capital investment decisions?

A
  • Interest rates
  • Economic growth
  • Confidence/expectations
  • Technology development
  • Availability of finance from banks
  • Deprication, wage costs, inflation and government policy
20
Q

What is sensitivity analysis?

A
  • Allows key assumptions to be changed to analyse the effect
  • Helps to judge the degree of risk
  • Recognises there is no such thing as an accurate forecast
  • Considers one varial/assumption at a time
21
Q

What are the advantages of sensitivity analysis?

A
  • Helps assess risks and prepare for less than favourable scenario
  • Identifies the most significant assumptions
  • Helps make precess of business forecasting more robust
22
Q

What are the disadvantages of sensitivity analysis?

A
  • Only tests one assumption at a time
  • Only as good as the data which the forecast is based upon
  • Complicated concept

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