6 & 7. Investment Appraisal

Question 1

What are the methods of evaluating investment

Answer 1

Traditional methods

• payback
• accounting rate return

Discounted cash flow (DCF) techniques

• net present value
• internal rate of return

Question 2

What is Payback

Answer 2

Measures the time taken for capital invested to be recouped
Estimates cash flow using pre- depreciation ‘profits’
Company’s either select the quickest or have a target payback period

If it gives returns yearly create a cumulative column for each year

Question 3

Pros and cons with payback

Answer 3

Easy to calculate
Useful if short term liquidity is an issue

Cons
Doesn’t consider whole life of project
Ignores that money loses value over time

Question 4

Accounting rate of return formula

Answer 4

Estimated average annual profit / estimated average investment *100

Question 5

Pros and cons of Accounting rate of return

Answer 5

Uses profit
Depreciation affects both investment and profit
Ignores the time value of money

Question 6

What is a differential condition

Answer 6

All costs that arise becuase of decisions we made - relevant

Question 7

What are future cost conditions

Answer 7

Only tomorrow can be changed
Past, sunk costs ignored
Future payments based on past decisions are ignored
Future payments must also be differential

Question 8

What are cash flow conditions

Answer 8

Difference between profit and cash
Income and expenditure - accrual based
Receipts + payments - cash
Depreciation not included

Question 9

When would you accept or reject NPV

Answer 9

If positive accept as it’s greater then cost

If negative reject as it’s less then present value

Question 10

What is needed in NPV table

Answer 10

Year
Cash flow
Tax
Discount factor 
Present value

Question 11

NPV pros and cons

Answer 11

Pros
Includes time value of money
Relevant cash flows
NPV is increase in SHW

Cons
Have to find a subtitle discount rate
Can be difficult to understand

Question 12

Internal rate of return

Answer 12

Represents the most a company can afford to pay for its capital

Question 13

IRR pros n cons

Answer 13

Easy to understand (%)
Takes all cash flow and time value of money into account

Cons
Uneven cash flow can give misleading answer

Question 14

Tax

Answer 14

Tax is assumed to be 1 year behind cash flow

Question 15

What is the nominal rate

Answer 15

Nominal rate is the real rate * inflation

Nominal = (1 + real) * (1 + nominal)