3.8 - Investment Appraisal

Question 1

What is investment appraisal

Answer 1

•Investment appraisal refers to the quantitative techniques used to calculate the financial costs and benefits of an investment decision.
•It aims to establish if it is worth pursuing a particular business and if it will be profitable
•It also helps the business to compare different investment projects.

Question 2

What are the 2 methods of investment appraisal

Answer 2

• the payback period (pbp)
• the average rate of return (arr)

Question 3

Define payback period

Answer 3

Estimates the period of time for an investment project to earn enough profits to repay the costs of the initial investment. Looking at how long the business will take to recover its initial investment from it net cash flow.

Question 4

State the payback period equation

Answer 4

Payback period = initial investment cash flow/annual cash flow from investment

Question 5

How would you solve this -

a firm wants to build a new sports facility and the initial investment will be £1 million. It is expected to generate the following net cash flows during the first 4 years: £200,000, £340,000, £430,000 and £360,000.

Answer 5

1.We need to calculate the cumulative cash inflow
2.Determine in which exact month of the 4th year the initial investment was paid back.

Question 6

What is the table for expected cash flow

Answer 6

Column 1 - year
Column 2 - annual net cash flows
Column 3 - cumulative cash flows

Minus the annual net cash flow from the cumulative cash flow to get that years cumulative cash flow

Question 7

What are the advantages of payback period

Answer 7

1. Simple calculation that tells the firm whether an investment will meet its cost
2. Easy method to compare with other investments
3. Time focused which is especially important for companies that have liquidity problems (remember that companies typically fail because of cash flow issues, not profitability)
4. Focuses on short term which is when forecasts are more likely to be correct

Question 8

What are the disadvantages of payback period

Answer 8

1. Ignores potential gains that happen after payback period has occurred. This could influence major decisions
2. Ignores the profitability of the project by focusing only on how quickly will be paid back.
3. Focus is on time instead of return. This puts too much focus on short term goals.
4. Does not consider external factor that might affect demand, which could affect the payback period.

Question 9

Define the average rate of return

Answer 9

Also know as the “Accounting rate of return” it measures the annual net return on an investment as a percentage of its capital cost. It assesses the annual profitability generated by the project over a period of time.

Question 10

State the formula for average rate of return

Answer 10

Average rate of return = total returns - capital cost/years of usage
/ capital cost X 100

Question 11

State the formula for net return per annum

Answer 11

Net return per annum = total returns - capital cost/ years of usage

Question 12

What are the advantages of average rate of return

Answer 12

1. Simple calculation that will show the profitability of an investment in a given period of time. That is, whether an investment will return more or less than a specific benchmark.
2. It makes use of all the cash flows in a business (unlike the PBP)
3. Easy metric to compare with other investments

Question 13

What are the disadvantages of average rate of return

Answer 13

1. Does not take time into consideration. There is more scope for errors (even last years investment) leading to an incorrect ARR.
2. Does not include time value of money. Would you rather have a £1,000 today or £1,000 5 years from now? ARR does not differentiate this.
3. It does not consider the timing of cash inflows. Two projects might have the same ARR but one could pay back quicker than the other

Question 14

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