decision - making techniques

Question 1

investment appraisal

Answer 1

the process of using forecast cash flows to assess the financial attractiveness of an investment decision, linked with a consideration of non-financial factors

Question 2

three methods of investment appraisal

Answer 2

• payback period
• average rate of return (ARR)
• net present value (NPV)

Question 3

payback period

Answer 3

assessing the period of time a business must wait until its initial investment has been recovered

Question 4

why can the payback period help a business

Answer 4

allows a firm to prioritise risk reduction when making investment decisions

Question 5

payback period calculation

Answer 5

payback occurs when the CUMULATIVE cash flow reaches zero

FORMULA: (amount needed / next amount ) x 12

Question 6

is it better to have quicker or longer payback

Answer 6

it calculates the length of time that the money is invested at risk, therefore quicker payback is best, however it may not always turn out to be most profitable in the long term

Question 7

average rate of return

Answer 7

this method considers the profit generated by an investment

Question 8

average rate of return Calculation (3 steps)

Answer 8

1 - calculate total profit over the lifetime of the project by adding all the net cash flows and deducting the initial outlay
2 - divide by the number of years the project lasts
3 - formula: (average annual profit / initial outlay) x100

Question 9

what does a higher ARR mean

Answer 9

the higher the ARR the more profitable the investment

Question 10

Net present value (NPV) using discounted cash flows

Answer 10

money tied up in an investment has an opportunity cost. This can be accounted for by discounting the value of future cash flows to allow for a given percentage return that could be achieved if the money were available now

Question 11

Time value of money

Answer 11

The time value of money is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity through investment and other factors such as inflation expectations.

Question 12

NPV calculation

Answer 12

each years net cash flow is multiplied by the relevant discount factor.
These are then totalled to give the overall NPV of the project

Question 13

what does a positive NPV mean

Answer 13

that a project generates a greater return on its initial outlay than putting money in the bank at an interest rate equal to the percentage discount factor used.
Higher figure = more profitable it will be

Question 14

strengths of using payback

Answer 14

• easy to calculate
• may be more accurate as it ignores long-term forecasts
• takes into account the timing of cash flow
• useful for a business with weak cash flow

Question 15

limitations of using payback

Answer 15

• tells us nothing about profitability
• ignores what happens once payback achieved
• may encourage short termism attitude

Question 16

strengths of using ARR

Answer 16

• clear focus on profitability
• considers cash flows over the whole projects lifetime
• easy to compare with other measures of return expressed as percentages (interest rates)

Question 17

limitations of using ARR

Answer 17

• ignores cash flow timing
• values far distant inflows as more immediate inflow
• including forecast data from far in the future may reduce the reliability

Question 18

strengths of using NPV

Answer 18

• takes opportunity cost of money into account

- considers both amount and timing of cash flows to indicate profitability

Question 19

limitations of using NPV

Answer 19

• complex to calculate
• meaning is often misunderstood
• only comparable between different projects if the initial outlay is the same

Question 20

other non financial factors to consider that may affect investment decisions

Answer 20

• corporate objectives (does investment focus on firm aims)
• company finances (expensive investments place firms financial health at risk)
• confidence in data (its always worth considering accuracy of data)
• social responsibility (some businesses may proceed in a project that may not be most financially attractive because it meets their social responsibilities

Question 21

typical investment appraisal targets

Answer 21

• Payback in 3 years (depends on investment size)
• ARR of at least 15%
• Positive NPV using 10% discount factors