Investment Appraisal Flashcards
Why is investment risky?
Investment carries an element of risk as you are spending capital in hopes of making more capital, and you are not guaranteed to make back the money invested, ideally businesses want low risks and high returns - businesses need to do this to achieve their objectives.
How can businesses ascertain the risks and rewards of a project or investment?
They will gather as much information as possible and data which will allow them to work out the risks and associated rewards of an investment.
What questions do firms try to answer when trying to make a good investment decision?
How long will it take for the money they invest to return?
How much profit will they make from the investment?
What are the three main methods for working out whether an investment is worth the risk?
Payback, ARR and NPV.
What do these methods do?
They use predicted cash flows for different projects that a firm is considering to try and gauge which one will give them the best return, as well as more specifically how much will need to be spent and when, as well as how much may be gained, and when. The faster the projected returns come in, the less risky a project will appear.
What is the major flaw in investment appraisal?
Only as good as the data used to calculate them.
What are the risks associated with IAs?
They are all based on predictions, so if one is wrong then it could be very costly to the business.
What is the purpose of the payback method?
It calculates the time required for a business to regain all the capital spent on their original investment.
How is it calculated?
Firstly, you need to know a businesses annual net cash flow - money generated from project per year - money invested in project.
If a project has a consistent annual net cash flow, how is the payback period calculated?
Payback period = Amount invested/Annual net cash flow per year
If the payback period is more complicated and you have to work out the months needed to pay back, what do you do? Project A = 50,000 with annual net cash flows being 12,500, 17,500, 30,000 and 45,000?
What does working out Average Rate of Return (ARR) do?
It compares the net return with the level of investment, thus focussing on profitability.
What is the net return?
The income minus costs, including the investment.
What is the formula for ARR?
ARR = Average Net Return/Investment x 100
What steps are needed before using the ARR formula?
You first need to find the total profit from the project, this is found by; Total net cash flows - investment.
Once you have the profit; divide that by the number of years of the investment. Which will give the Average annual return (AAR).
Then, divide the AAR by the investment amount and multiply by 100 to get the ARR.
E.g. Total net cash flow = £51k, investment is £35,000, find the ARR. Over 5 years.
Profit = Total Net Cash Flow - Investment
= 51K - 35K = 16K
AAR= Profit/ No of years
AAR = 16,000/5 = £3200.
ARR = (AAR/Investment) x 100
ARR = (3200/35000) x 100 = 9.14% (This 9.14 could be thought of as interest from the 35,000 each year, essentially they would be making £35,000 + 9.14% of 35,000 each year.)
Examine this example
