3.8 Investment Appraisal

Question 1

Investment Appraisal

Answer 1

• Large amount of money spent at the beginning
• series of smaller positive money coming in over time
• Quantitative techniques to assess the profitability or desirability of a project

Question 2

Payback period

Answer 2

Length of time for net cash inflows to be larger than the original investment

to calculate the months you do the fraction of the year x 12 = X months

Question 3

Average Rate of Return (ARR)

Answer 3

Measures the annual profitability of a project as a percentage of the initial capital cost

Question 4

ARR formula for percentage

Answer 4

Average annual profit x 100
initial capital cost

Question 5

Formula for Average Annual Profit

Answer 5

total profit
years

Question 6

4 steps to ARR

Answer 6

1) calculate the total profit
2) divide by years
3) divide by original cost
4) x 100

Question 7

Pros to payback

Answer 7

• quick and easy to understand

Question 8

Cons to payback

Answer 8

• Ignores later cash flowes after the payback (which may be larger)
• could encourage short-term thinking
• does not account for inflation

Question 9

Pros to ARR

Answer 9

• uses all cash flows

Question 10

Cons to ARR

Answer 10

• ignores timing of the larger cash flows
• also does not account for inflation

Question 11

Net Present Value (NPV)

Answer 11

the value of the money earned with inflation accounted for

• takes account of the time value of money
• but assumptions have to made about the discount rate to use