Investment Appraisal (05)

Question 1

SUMMARY

Answer 1

In summary, the following are covered in this topic:
1. Investment appraisal is a process of using quantitative techniques that assess
the financial feasibility of a project.
2. Investment appraisal is important due to the large amount of company
resources used, opportunity cost, as well as the impact on shareholders’ wealth.
3. The risks in making investment decisions include the political climate, state of
economy, project duration and nature of market.
4. The investment appraisal techniques include payback, the average rate of
return and net present value.
5. Payback period records the time taken for the net cash inflows to pay back the
original capital cost of investment.
6. The average rate of return (ARR) measures the annual profitability of an
investment as a percentage of the initial investment.
7. Average rate of return considers the total return (yield) over the whole life of
the investment.
8. The net present value (NPV) measures today’s value of the estimated cash flows
resulting from an investment.

Question 2

ARR(%) formula

Answer 2

ARR(%) = Annual profit (net cash flow) / Initial capital cost x 100

Year Net cashflow ($)
0 (20 000)
1 5 000
2 11 000
3 10 000
4 10 000

The steps to calculating ARR is as follows.
1 Add up all positive cash flows $5000 + 11 000 + $10 000 + $10 000
= $36 000

2 Subtract cost of investment $36 000 - $20 000 = $16 000
This is the total net cash flow

3 Divide by life span $16 000 / 4 = $4000

This is the annual profit or net cash flow

4 Calculate ARR using the formula $4000/ $20 000 x 100 = 20%

Question 3

Advantages of ARR

Answer 3

 Unlike the payback method, ARR considers the entire cash flows.
 ARR focuses on profitability, which is a key objective for most businesses.
 The result is easily understood and comparable with other investment projects
competing for the limited funds available.
 The result can be quickly assessed against a predetermined criterion rate set by
the business.

Question 4

Disadvantages of ARR

Answer 4

 ARR ignores the timing of cash flows. This could result in two projects having
similar ARR results, but one could pay back much earlier than the other one.
 As all cash inflows are included, the later cash flows, which are less likely to be
accurate, are included in the calculation.
 The time value of money is ignored, as the cash flows have not been discounted.

Question 5

Advantage of NPV

Answer 5

 It considers both the timing and size of cash flows in the appraisal.
 The discount rate could be varied to allow for changes in economic conditions.
 It considers the time value of money and takes the opportunity cost of money
into account.

Question 6

Disadvantages of NPV

Answer 6

 It is reasonably complex to calculate and explain.
 The NPV calculated depends on the discount rate used, and expectations about
interest rates may be inaccurate.
 NPV can be compared with other projects, only if the initial cost of investment
is identical. This is because NPV does not provide a percentage rate of return on
the investment.