3.8 - Investment Appraisal

Question 1

what is investment appraisal

Answer 1

quantitative technique to assess the profitability or desirability of investing in a project

• how fast will an initial large investment be repaid into the business?

Question 2

what are two types of risk?

Answer 2

• systematic risk
• specific risk

Question 3

what is systematic risk

Answer 3

risk which is based on outside factors - eg. exchange rates

Question 4

what is specific risk

Answer 4

risk based on the project itself - eg. little knowledge in the sector

Question 5

what is payback period?

Answer 5

the length of time that it takes for the cost of the intial investment to be repaid into the business as earnings

Question 6

pros/cons of using payback period as a method of investment appraisal

Answer 6

pros
* easy to calculate
* easy to understand
* relevant to firms with limited funds - want quick returns

cons
* just estimates - may not be correct
* ignores timings of finances being paid back
* does not calculate profit

Question 7

how is the payback period calculated?

Answer 7

1. draw the table
2. find the point on the accumalated cash flow where it goes from + to -
3. if this is not a clear value, find how much is required to reach 0 from the negative point, and put it over the annual net cash flow being added on top of the negative number when it turns positive

(x fraction by 12 to find the fraction of a year as a number of months)

Question 8

what is average rate of return (ARR)

Answer 8

method of investment appraisal where the profitability of a project is calculated as the annual percentage return of the initial capital cost

Question 9

how is the average rate of return (ARR) calculated?

Answer 9

using the triangle method

bottom right divided by bottom left divided by top middle

AKA:

Question 10

when making a table to calculate average rate of return (ARR), what should the headings be?

Answer 10

1. year
2. annual net cashflows
3. accumalated cashflow

Question 11

what is net present value (NPV)

Answer 11

using a discount factor, businesses foreshadow inflation numbers to get a more realistic value of their investment into a project over a period of time

Question 12

pros/cons of using average rate of return (ARR)

Answer 12

pros
* easy calculation - allows businesses to forsee a return on their investments
* measures profit recieved on different projects

cons
* estimates, may not be correct
* ignores timing of payments

Question 13

how to calculate net present value (NPV)

Answer 13

1. make a table
2. input years
3. input annual net cashflows
4. input discount factor
5. multiply annual net cashflows by discount factors
6. write in accumalated cashflow

add all of the values in accumalated cashflow to find the NPV

Question 14

pros/cons of using net present value (NPV) as a form of investment appraisal

Answer 14

pros
* takes into account the changing value of money over time
* gives businesses an overall view of how profitable a project may be over time

cons
* inflation rates may change - may not 100% be accurate
* complex to calcualte - easily misunderstood