3.7.8 Investment Appraisal

Question 1

What is investment appraisal

Answer 1

A series of techniques designed to assist a business in judging the desirability of investing in particular projects

Question 2

When may investment appraisal be used to aid a business in making decisions

Answer 2

When investing in:

• Non - current assets
• Launching new products
• New technology
• Expansion
• Infrastructure

Question 3

Financial methods of investment appraisal?

Answer 3

Payback - calculates the length of time it takes for an investment to recoup original cost

Average rate of return - calculates the annual rate of return over the life of an investment in order to compare the investment with other alternatives

Net present value - can be used alongside other techniques and considers the future value of an investment by discounting the decreased future value of money

Question 4

Why might a business calculate payback

Answer 4

Businesses who need a quick rate of return and face liquidity problems may want to calculate payback

Question 5

Why is ARR useful

Answer 5

Measures the profit achieved of an investment over time, which can then be compared to other investments or the zero risk strategy of leaving money in the bank account

Question 6

Downfall of ARR

Answer 6

Profits may fluctuate considerably over the life of a project and this is not taken into account

Question 7

ARR is calculated by

Answer 7

Average annual profit / assets initial cost

Question 8

Three steps taken into calculating ARR

Answer 8

1) total income from investment - cost of investment = total profit from investment
2) total profit of investment / expected life span of asset = average annual profit
3) average annual profit / cost of investment x 100 = ARR

Question 9

When is the average rate of return useful

Answer 9

When making investment decisions as it allows a business to directly compare potential investments in terms of the average profit they will generate over the life of the project/asset

Question 10

What does Net present value take into account and what does it consider

Answer 10

Takes into account the future value of money by discounting cash flows. NPV considers time in an investment and follows the principle that value of money depreciates over time.

Question 11

What are two financial factors a business may use to evaluate potential investment

Answer 11

The rate of interest - use a current rate of interest as a benchmark to judge investments against

ROCE - is there an expected minimum % return on the investment

Cost - can a firm finance the investment

Question 12

What are two non financial factors a business might use to evaluate a potential investment

Answer 12

Corporate objective - does the investment support business strategy
Ethics - does the investment support CSR policy
Industrial relations - what will be the impact on employees

Question 13

What is risk

Answer 13

Risk is the chance of an adverse outcome and the impact it may have

Question 14

What might determine the risk associated with particular investments

Answer 14

• timescale of investments
• knowledge / expertise of the business in the investment
• if the investment is in a new market
• stability of external environment (legal,political and social etc)

Question 15

How can a business reduced the impact of a negative outcome when it comes to risk

Answer 15

By agreeing prices in advance, providing allowances for revenues and costs, ensuring the firm has sufficient financial assets.

Question 16

What is sensitivity analysis

Answer 16

Involves using variations in forecasting to allow for a range of outcomes. Allows a business to ask what if questions and put in place plans to deal with these scenarios.

Question 17

Examples of sensitivity analysis might include

Answer 17

• comparing NPV using a variety of discount factors
• allowing for a 20% fluctuations in sales and costs
• builiding in contingency for unforeseen expenses

Question 18

What is sensitivity analysis useful for

Answer 18

Useful for identifying the possible risks involved in an investment if only a few variables are considered, the value of it depends on the accuracy of the data on which it is based on.