Chapter 53- Investment Appraisal

Question 1

Investments

Answer 1

refers to the purchase of capital goods- capital goods are Used in the production of other goods – for example, a building contractor who buys a cement mixer, some scaffolding, a lorry, a computer etc. – an investment might also refer to expenditure by a business that is likely to yield a return in the future such as investing in research and development.

Question 2

Investment appraisal

Answer 2

Describes how a business might objectively evaluate an investment project to determine whether or not it is likely to be profitable – allows businesses to make comparisons between different investment projects.

Question 3

Capital cost

Answer 3

Amount of money spent when setting up a new venture

Question 4

Net cash flow

Answer 4

Cash flow minus cash outflows

Question 5

Payback

Answer 5

Find how many years and months something takes to pay off. For example, an engineer may invest 500,000£ in new cutting machinery and estimate that it will lead to net cash flow over the next five years. The payback period can also be found be calculating the cumulative net cash flow each year taking into account the initial cost of the machine.

Advantages:
•Useful when technology changes rapidly as important to recover costs of investment before new mode/equipment designed e.g. agriculture industry
•Simple to use
•Firms may adopt if have cash flow problems because project chosen will ‘payback’ investment more quickly than others.

Disadvantages:
• Cash earned after payback period ignored
• Profitability of method over looked

Question 6

Average rate of return (A.R.R)

Answer 6

Add up all the inflows- £70,000
Take away from inflows the outflow figure- £70,000-£50,000= £20,000
Divide by the number of years- £20,000/5 = £4,000
Take that answer divide by cost of project x100
£4000/£50,000 x100 = 8%

Advantages:
•Its shows clearly the profitability of an investment project
•Allows range of projects to be compared
•The overall rate of return can be compared to other uses for investment funds
•Makes it easier to identify the opportunity cost of investment

Disadvantages:
•The effects of time on the value of money are ignored

Question 7

Net present value

Answer 7

The NPV method attempts to convert future cash flow values into present day values. Uses discount factors to make this calculation and these discounts equate to a rate of interest that the business could earn on any investment.

Advantages:
•This method correctly accounts for the value of future earnings by calculating present values
•The discount rate used can be changed as risk and conditions in financial markets change

Disadvantages:
•Calculation is more complex
•Rate of discount is critical- if it is high, fewer projects will be profitable

Question 8

Advantages of the discounted cash-flow method

Answer 8

• Correctly accounts for the value of future earnings by calculating present values
• Discount rate used can be changed as risk and conditions in financial markets change

Question 9

Limitations of these methods

Answer 9

Simple payback – cash earned after the payback period is ignored – the profitability of the method is overlooked

Average rate of return – the effects of time on the value of money are ignored

Discounted cash flow – The calculation is more complex than other methods