3.8 Investment appraisal

Question 1

Investment appraisal

Answer 1

Quantitative techniques used to calculate the financial costs and benefits of an investment decision.

Question 2

Payback period (PBP)

Answer 2

The amount of time needed for an investment project to earn enough profit to repay the initial cost of the investment.

Question 3

Payback period (PBP) formula

Answer 3

payback in last negative year / net cash flow in the first positive year x 12 months

Question 4

Advantages of PBP

Answer 4

• simplest and easiest method of investment appraisal
• useful for firms with cash flow problems
• allows the firm to see whether it will break-even on the purchase
• can be used to compare different investment projects

Question 5

Limitations of PBP

Answer 5

• contribution per month is unlikely to be constant
• focuses on investment, rather than profit
• encourages short-term approach to investment

Question 6

Average rate of return (ARR)

Answer 6

Measures the annual profitability of an investment as a percentage of the initial investment.

Question 7

Average rate of return (ARR) formula

Answer 7

average annual profit / initial amount invested x 100%

Question 8

How to calculate ARR

Answer 8

1. Add all positive cash flow
2. Subtract cost of investment
3. Divide by lifespan (annual profit)
4. Calculate annual profit as a percentage

Question 9

Advantages of ARR

Answer 9

• uses cash flows
• focuses on profitability
• results are easy to understand

Question 10

Limitations of ARR

Answer 10

• ignores the timing of the cash flows
• later cash flows are likely to be inaccurate

Question 11

Net present value (NVP)

Answer 11

Today’s value of the estimated
cash flows resulting from an
investment.

Question 12

Net present value (NVP) formula

Answer 12

Sum of Present Values - Cost of Investment

Question 13

How to calculate NVP

Answer 13

1. Multiply discount factors by the cash flows
2. Add the discounted cash flows
3. Subtract the capital cost of investment

Question 14

Discount factors

Answer 14

Used to obtain present value of future cash flows, multiply the appropriate discount factor by the cash flow.

Question 15

Advantages of NVP

Answer 15

• considers both timing of cash flows and their size
• the rate of discount can be varied to allow for different economic circumstances
• considers the time value of money

Question 16

Limitations of NVP

Answer 16

• reasonably complex and complicated to explain
• financial results depend on the discount rate used that may be inaccurate
• doesn’t provide a percentage of return