Chapter 33 (investment appraisal)

Question 1

investment appraisal is?

Answer 1

evaluating the profitability or desirability of an investemnt

Question 2

what info do you need to appraise an investment?

Answer 2

1. the initial capital cost of the venture, including e.g equipment and machinery + installation costs.
2. estimated life expectancy - how many years till return can be expected.
3. the residual value
4. annual forecasted net cash flows

Question 3

residual value is

Answer 3

known also as scrap value. at the end of an investments useful life span, the residual value is the additional net return earned

Question 4

The five quantitive methods of appraisal are?

Answer 4

1. payback period
2. average rate of return (A.R.R)
3. discounted payback
4. net present value
5. internal rate of return

Question 5

annual forecasted net cash flows is

Answer 5

the forecast cash inflows - forecast cash outflows

Question 6

what external factors could affect the revenue forecast?

Answer 6

1. an economic recession
2. fluctuation in the price necessary goods
3. new advancements in technology
4. competitors expanding, or growing.

Question 7

payback period formulae

Answer 7

additional net cash inflow needed
x12
annual cash flow flow in that year

Question 8

payback period is?

Answer 8

length of time it takes for the net cash inflows to pay back the original capital cost of the investment

Question 9

2 reasons payback period is important

Answer 9

1. a business may have borrowed the finance, a long payback period will increase interest payments
2. the more time the finance isn’t made back the more uncertain it becomes

Question 10

advantages to payback period

Answer 10

1. it is quick and easy to calculate
2. the results are easily understood
3. useful in eliminating investment that wont pay pack within a certain time period
4. useful for companies where liquidity is os greater importance than overall profitability
5. the speedier the payback the quicker that money can be reinvested

Question 11

disadvantages to payback period

Answer 11

1. it does not measure the overall profitability of the firm

2. the focus on the short term, business might miss an opportunity just cause it may take longer

Question 12

Average Rate of Return (A.R.R)

Answer 12

measure the annual profitability of an investment as a percentage of the initial investment.

Question 13

Average Rate of Return (A.R.R) formulae

Answer 13

annual profit (net cash flow)
x100
initial investment
=___%

Question 14

four stages of calculating A.R.R

Answer 14

1. add up all positive cash flows.
2. subtract cost of investment (annual total profit)
3. divide by lifespan
4. Calculate the % return to find the A.R.R

Question 15

advantages of A.R.R

Answer 15

1. it uses all of the cash flows - unlike the payback method
2. it focuses on profitability, which is the central objective of many businesses
3. results easy to understand and compare with other A.R.R
4. the result can be quickly assessed against predetermined criterion rate (more than 15% normally)

Question 16

disadvantages of A.R.R

Answer 16

1. it ignores the timing of the cash flows. could result in 2 A.R.R’s having same % but one actually paying back quicker
2. all cash flows are needed, later cash flows are less accurate and are incorporated in the calculation
3. the time value of money is ignored

Question 17

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Answer 17

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