7.8 Investment appraisal (Analysing strategic options)

Question 1

Investment appraisal

Answer 1

Used to assess best financial option from quantitative perspective

Question 2

Payback

Answer 2

Measures time period for an investment to repay its original costs before it begins to yield profits.

Question 3

Month of payback formula

Answer 3

net cash flow next year / 12

Question 4

Advantages of payback

Answer 4

-Easy to understand
-simple to calculate

Question 5

Disadvantages of payback

Answer 5

-excludes income after payback period
-ignores timings of payments

Question 6

Average rate of return

Answer 6

Calculates percentage rate of return on each possible investment, allows easy comparison not just with different investments but with current interest rate offered by banks and building societies.

Question 7

Average profit

Answer 7

Profit / number of years

Question 8

Formula for average rate of return

Answer 8

average profit
——————– x 100
initial investment

Question 9

Advantages of average rate of return

Answer 9

-allows for easy comparisons in terms of percentage return on different projects as well as returns offered by banks.
-Relatively simple to calculate

Question 10

Disadvantages of average rate of return

Answer 10

-uses average profits which can fluctuate
-so not always accurate

Question 11

Net present value

Answer 11

Measures the time value of money
-‘discounting interest’
(Takes into account time value of money, therefore involves discounting interest instead of adding it on)

Question 12

Advantages of net present value

Answer 12

-Accounts for time value of money unlike payback and ARR
-Easily comparable between projects

Question 13

Disadvantages of net present value

Answer 13

-Difficult concept to understand
-Difficult to estimate accurate discount factors

Question 14

Factors influencing investment decisions

Answer 14

-current level of interest rate
-current level of profit business has
-opportunity cost of each investment
-Corporate image of the business (does it align with the business?)
-ethical or environmental considerations
-industrial relations e.g trade unions (will investment have impact on employees?)

Question 15

Sensitivity analysis

Answer 15

-Process of systematically changing variables to calculate range of possible financial outcomes.
-testing various scenarios including best + worst case.

Question 16

examples of changing variables

Answer 16

expected cash inflows
expected cash outflows
discount factor
number of years business will make a profit

Question 17

how is sensitivity analysis useful?

Answer 17

It assists managers in considering degree of risk in an investment, allowing them to develop contingency plan.