Component 2 - Investment appraisal

Question 1

Explain : What is meant by investment appraisal

Answer 1

Investment Appraisal is process of evaluating an investment/project to determine whether it is worth undertaking.

Question 2

Explain : The purpose of investment appraisal + 3 Benefits

Answer 2

To analyse the costs and benefits of an investment and compare them to the expected return, in order to assess if the investment is financially viable.

1) More Efficient resource allocation

2) It Minimises Risk

3) To ensure that investments are aligned with the overall strategic objectives of the organization.

Question 3

Explain : The Three Different Types of investment appraisal

Answer 3

1) Net Present Value

2) Internal Rate of Return

3) Payback period

Question 4

Calculate : What is the payback period of an investment and What is the formula

Answer 4

The payback period of an investment is a measure of how long it takes to recover the initial cost of an investment.

Example:

Initial cost of the investment: $100,000
Expected annual cash inflows: $30,000
Payback period = Initial cost / Annual cash inflows
Payback period = $100,000 / $30,000
Payback period = 3.33 years

Question 5

Calculate : Calculate and interpret the payback period of an
investment in years and months

Answer 5

The payback period of an investment is a measure of how long it takes to recover the initial cost of an investment.

Example:

Initial cost of the investment: $100,000
Expected annual cash inflows: $30,000
Payback period = Initial cost / Annual cash inflows
Payback period = $100,000 / $30,000
Payback period = 3.33 years

Question 6

Calculate : What is the formula for ARR and how can it be interpreted

Answer 6

Here is the formula to calculate ARR:

ARR = (average net per year / cost of Investment) * 100

A higher ARR generally indicates a more profitable investment, and therefore, a more attractive investment opportunity.

Question 7

Calculate : Use discounted cash flow (DCF) to calculate and interpret
the net present value (NPV) of an investment
(discount factors will be provided and
do not need to be calculated)

Answer 7

The discounted cash flow (DCF) method of investment appraisal involves using discounted future cash flows to determine the present value of an investment. The net present value (NPV) of an investment is calculated by subtracting the initial investment amount from the present value of the expected cash flows.

To calculate NPV, the expected cash flows are discounted using a discount factor that takes into account the time value of money and the required rate of return of the investment. The discount factor will be provided in the scenario. The discounted cash flows are then summed up to give the present value of the expected cash flows. This value is then subtracted from the initial investment amount to give the NPV.

For example, if an investment has an initial cost of £100,000 and is expected to generate cash flows of £20,000 per year for 5 years with a discount factor of 10%, the NPV can be calculated as follows:

NPV = -£100,000 + (£20,000 / (1 + 0.10)) + (£20,000 / (1 + 0.10)^2) + (£20,000 / (1 + 0.10)^3) + (£20,000 / (1 + 0.10)^4) + (£20,000 / (1 + 0.10)^5)

If the NPV is positive, it means the investment is expected to generate a return greater than the required rate of return, and is therefore a good investment. If the NPV is negative, it means the investment is expected to generate a return lower than the required rate of return, and is therefore a poor investment.

Question 8

Evaluate :”Evaluate the advantages and disadvantages of the different
investment appraisal methods to a business and its stakeholders”

Question 9

Evaluate