Basic investment appraisal techniques

Question 1

What is the accounting rate of return (ROCE)?

Answer 1

ARR = Average annual pre tax profit

Initial or average investment

Question 2

What are the advantages to ARR/ROCE?

Answer 2

• Simple to calculate
• Answer is a % so easily comparible
• Considers the projects entire life

Question 3

What are the disadvantages of ARR/ROCE?

Answer 3

• Based on profits not cash ( subjective)
• % answer is not absolute
• Ignores the time value of money

Question 4

If ARR is < target you should…

Answer 4

Rejected the project

Question 5

The payback period mesasures how long it takes for the net cash flows generated by the project to recover the initial investment. How do you calculate it?

Answer 5

1. Calc the cumulative net cash flow each year
2. Determine at which point the initial outlay is recovered

Question 6

What are the 4 main advantages to Payback period?

Answer 6

• Simple, easy to understand
• Based on cashflow
• Favours short term projects minimising business and financial risk
• Can be used in capital rationing to identify projects which generate additional cash for investment quickly

Question 7

What the disadvantages of payback periods?

Answer 7

• Ignores time value of money
• No guide to an acceptable time period
• Ignores cashflows after the payback period.

Question 8

What is the short cut for calculating the payback period if there’s a constant cash flow?

Answer 8

Initial investment

Constant annual cash flow

Question 9

What is considered not to be a relvant cash flow for investment appraisal?

Answer 9

• Sunk costs
• commited costs
• Non cash items
• Allocated costs