3.8 - Investment Appraisal

Question 1

Investment Appraisal

Answer 1

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

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

Evaluating Payback (Pros and Cons)

Answer 4

• Quick and easy to understand
• Ignores later cash flows after the payback (which may be larger)
• Could encourage short-term thinking

Question 5

Evaluating ARR (Pros and Cons)

Answer 5

• Uses all cash flows
• Can compare to returns on other investments
• Ignores timing of the larger cash flows

Question 6

Net Present Value (NPV)

Answer 6

The sum of all future cash flows over the investment’s lifetime, discounted to the present value

Question 7

How to calculate ARR?

Answer 7

1. Calculate the total profit
2. Divide by years
3. Divide by original cost
4. X 100

Question 8

How to calculate NPV?

Answer 8

1. Annual Net Cash Flow x Discount Factor = Discounted Net Cash Flow
2. Add all values of Discounted Net Cash Flow

Question 9

How to calculate Payback Period?

Answer 9

Question 10

Pros and Cons of NPV

Answer 10

• Takes account of the time value of money
• But assumptions have to be made about the discount rate to use