Chapter 35 Investments appraisal

Question 1

Define investment appraisal

Answer 1

Evaluating the profitability or desirability of an investment project

Assessing weather in The Likely future returns on a project will be greater than the cost and by how much

Question 2

Information needed to be able to undertake a quantitative investment appraisal

Answer 2

Initial capital costs of the investment
Estimated life expectancy
The expected residual value (additional net returns from the sale of the asset at the end of its useful life)
Forecasted net returns or net cash flows from the project (expected returns less running costs)

Question 3

Methods of quantitative investment appraisal

Answer 3

Payback period
Average rate of return
Net present value
Internal rate of return
Discounted payback

Question 4

Define payback period

Answer 4

The payback period is the length of time it takes for net cash inflows to pay back the original capital costs of the investment.

Question 5

Why is payback period important?

Answer 5

A business may have borrowed the finance for the investment => longer payback period will increase interest payments
Even if the finance was obtained internally, the capital has an opportunity cost => the speedier the payback, the quicker the capital is made available for other projects
The longer the project continues, the more uncertain it becomes since changes in the environment is difficult to manage
Some managers are risk averse => quick payback reduces uncertainties
Cash flows received in the future have less real value than cash flows today due to inflation. The quicker, the higher the real value will be

Question 6

Advantages of payback period

Answer 6

It is quick and easy to calculate
Easily understood
Emphasis on speed of return gives the benefit of concentrating on the more accurate short term forecast of the project’s profitability
Result can be used to screen out projects that aren’t feasible
Useful for business where liquidity > profitability

Question 7

Disadvantages of payback period

Answer 7

Does not measure the overall profitability of a project as it ignores all the cash flows after the payback period. It may be possible for an investment to give a rapid return of capital, but then to offer no other cash inflows
Concentration on short term may lead to businesses to reject profitable long term investments
Does not consider the timing of the cash flows during the payback period

Question 8

Define average rate of return

Answer 8

The average rate of return (ARR) measures the annual profitability of an investment as a percentage of the initial investment.

Question 9

Advantages of ARR

Answer 9

Uses all of the cash flows
Focuses on profitability
Easily understood
Easy to compare
Can be quickly assessed against criterion rate

Question 10

Disadvantages of ARR

Answer 10

Ignores the timing of the cash flows => result in 2 projects having similar ARR results, but one could pay back much quickly than the other
As all cash flows are included the later ones are less likely to be accurate
Time value of money is ignored as the cash flows have not been discounted

Question 11

Define net present value

Answer 11

The net present value (NPV) measures today’s value of the estimated cash flows resulting from an investment.

Question 12

Advantages of NPV

Answer 12

It considers both the timing of cash flows and the size of them in arriving at an appraisal
The rate of discount can be varied to allow for different economic circumstances. e.g. could be increased if there was a general expectation that interest rates were about to rise
It considers the time value of money and takes the opportunity cost of money into account

Question 13

Disadvantages of NPV

Answer 13

Reasonably complex to calculate and explain
Final result depends greatly on the rate of discount used and expectations abt interest rates may be inaccurate
NPV can be compared with other projects but only if the initial capital cost is the same. This is because the method does not provide a % rate of return on investment

Question 14

Define internal rate of return

Answer 14

the rate of discount that yields a NPV of zero
the higher the IRR, the more profitable the investment project is

Question 15

What should IRR be compared with?

Answer 15

the IRR of other projects - the highest reflects the most profitable investment
the expected cost of capital or rate of interest and if IRR is greater, the project should be profitablem taking the cost of borrowed capital into account
a cut-off rate or criterion rate of return preset by the business

Question 16

Define criterion rate

Answer 16

the minimum levels (maximum for payback period) set by mgmt for investment appraisal results for a project to be accepted

Question 17

Advantages of IRR

Answer 17

By giving a percentage rate of return, different projects costing different amounts can be compared
Easily compared with the rate of interest or the criterion rate
Avoids the need to choose an actual rate of discount

Question 18

Disadvantages of IRR

Answer 18

tedious calculation => human errors
by giving an exact result, it can mislead business users into believing that investment appraisal is a precise process without risk and uncertainties

Question 19

Evaluation of investment appraisal

Answer 19

Analysing numerical results can mislead managers into assuming that the results are certain and definite. Rarely the case since uncertainties over future cash flows, operating costs, movements in interest rates and other variables. Can only be a guide
Much will depend on manager’s attitude towards risk and balance o be achieved between risk and potential future profits
Significance of objectives also depends greatly on the qualitative factors

Question 20

What are the qualitative factors?

Answer 20

Impact on environment
Planning permission
Aims and objectives of the business
Manager’s attitude towards risk