Investment Appraisal

Question 1

What is investment appraisal

Answer 1

Investment appraisal is 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

Average rate of return steps

Answer 2

Add all net cash flows together, minus initial outlay, divide by number of years, divide by initial investment x 100

Question 3

Limitation of paypack period

Answer 3

Assumes quicker payment is best so less risk but may not turn out to be most profitable in long term- does not consider time value of money. The payback method does not give a complete analysis as to the attractiveness of projects that receive cash flows after the end of the payback period. And it does not consider the profitability of a project nor its return on investment.

Question 4

Why NPV is better

Answer 4

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 and generated that return.

Question 5

Discount factor explained

Answer 5

Considering the likely rate of interest that will be missed out on by tying
money up in the investment allows the choice of a discount factor to use,
for example a 10% discount factor allows for a return of 10%. Bigger better, definite returns

Question 6

How to work out NPV

Answer 6

Times by discount factor, add all up then minus initial investment

Question 7

What does NPV show

Answer 7

A positive NPV shows that a project generates a greater return on its
initial outlay than simply putting the money in the bank at an interest
rate equal to the percentage discount factor used. The higher the figure,
the more profitable it will

Question 8

What does PaYback encourage

Answer 8

Short termism- the
tendency to focus on
achieving short-term
objectives by taking
decisions that may preclude
better, longer-term options.

Question 9

Some advantages of payback

Answer 9

Easy to calculate and understand
• May be more accurate as it ignores
longer-term forecasts which may be
less accurate
•Takes into account the timing of cash
flows
• Very useful for businesses with weak cash flow

Question 10

Main disadvantages of payback summarised

Answer 10

Tells us nothing about profitability, 
Ignores what happens after payback is
achieved,
May encourage a short-termist
attitude

Question 11

ARR Advantage

Answer 11

Clear focus on profitability,
Considers cash flows over the whole
return project's lifetime, Easy to compare with other measures
of return expressed as percentages,
such as interest rates

Question 12

ARR disadvantages

Answer 12

Ignores the timing of cash flows therefore values far distant inflows
as much as more immediate inflows,
which are worth’ more, Including forecast data from far in the
future may reduce the reliability of the
forecasts and therefore results

Question 13

NPV advantages

Answer 13

Takes the opportunity cost of money
into account,
Considers both amount and timing of
cash flows to indicate profitability. TIME VALUE OF MONEY AND DECISION-MAKING

Question 14

NPV disadvantages

Answer 14

Complex to calculate and
communicate (difficult concept to grasp), Meaning is often misunderstood, Only comparable between different projects if the initial outlay is the same, NPV also assumes the discount rate is the same over the life of the investment or project. Discount rates, like interest rates, can and do change year-to-year. NPV assumes you can accurately assess and predict future cash flows.

Question 15

Non-financial factors to consider when making a decision

Answer 15

Corporate objectives, company finances, confidence in the data, social resopnsibilities

Question 16

Corporate objective

Answer 16

Does the chosen investment focus on achieving the agreed objectives of the business?

Question 17

Company finances

Answer 17

Expensive investments that may place the firm’s financial health at risk if they require external finance may be better ignored.

Question 18

Confidence in the data

Answer 18

It is always worth considering the likely accuracy of the forecasts on which calculations are based: who prepared the forecasts; do they have a record of success in forecasting; do they have some bias that could cause them to over or underestimate cash flows?

Question 19

Social responsibilities

Answer 19

If an investment clearly helps to meet a business’ social responsibilities, some businesses may be willing to proceed even if the project is not the most financially attractive option.

Question 20

Capital expenditure

Answer 20

Cash spent on
investment in the
business: e.g.
Plant & machinery
Factory buildings
IT systems
Distribution equipment
Fixtures and fittings

Question 21

Revenue Expenditure

Answer 21

Cash spent on day-to-
day operations: e.g.
Raw materials
Energy costs
Wages and salaries
Marketing costs
Office administration

Question 22

Why capital expenditure is long term and link with non current asset

Answer 22

The main distinction is that capital
expenditure is on non-current
assets which have an
"economic
life" in the business - they are
intended to be kept, rather than
sold or turned into products

Question 23

Reasons for capital expenditure

Answer 23

To add extra production capacity
• To replace worn-out, broken or
obsolete machinery and equipment
• To support the introduction of new
products and production processes
• To implement improved IT systems
• To comply with changing legislation &regulations

Question 24

What do u have to consider before capital expenditure

Answer 24

The implication of scarce finance

Question 25

Investment appraisal short definition

Answer 25

The process of
analysing whether
investment projects
are worthwhile

Question 26

Payback period definition

Answer 26

The payback period is
the time it takes for a
project to repay its
initial investment