Investment Appraisal

Question 1

Investment appraisal:

Answer 1

Evaluating the probability or desirability of an investment project

-Managers use investment-appraisal techniques to asses whether the likely future returns on projects will greater than costs, and by how much

-Quantitative methods of appraisal will make comparisons between the cash outflows or costs of the project and the expected future cash inflows.

Question 2

Quantitative investment appraisal, information required:

Answer 2

• initial capital cost of the investment such as the cost of buildings and equipment
• estimated life expectancy or the ‘useful life’ of an asset
• residual value of the investment – at the end of their useful lives, the assets will be sold, leading to a further cash inflow
• forecasted net cash flows from the project. These are the expected returns from the investment less its annual operating cost.

-Very little of this financial data can be said to be certain. Quantitative techniques rely heavily on the reliability of financial estimates and forecasts.

Question 3

Forecasting cash flows in an uncertain environment:

Answer 3

Annual forecasted net cash flow: forecast cash inflows minus forecast cash outflows. It is assumed that:

• cash inflows are the same as the annual revenues earned from the project
• cash outflows are the initial capital cost of the investment and the annual operating costs.

-These net cash flow figures can then be compared with those of other projects and with the initial cost of the investment.

-Forecasting these figures is never easy and can also never be 100% accurate

Question 4

Effect of external factor on accuracy of forecasting

Answer 4

External Factors reduce the accuracy of forecasting

Question 5

The basic quantitative methods of investment appraisal are:

Answer 5

• Payback period
• Accounting (or average) rate of return. (ARR)

Question 6

Payback Period

Answer 6

The length of time it takes for the net cash inflows to pay back the original capital costs of the investments

Question 7

Why is Payback important?:

Answer 7

-A business may have borrowed the finance for investment and a long payback period would increase interest payments

-Even if the finance was obtained internally the capital has an opportunity cost

-The longer the pay back period the more uncertain the whole investment becomes. Difficult to predict changes in external factors over a longer period

-Some managers are risk averse and want to minimize the risk by quick payback

-Cash flow received in the future have less real value

Question 8

Advantages of Payback:

Answer 8

• It is quick and easy to calculate.
• The results are easily understood by managers.
• The emphasis on speed of return of cash flows gives the benefit of concentrating on the more accurate short-term forecasts of the project’s profitability.
• The result can be used to eliminate or identify projects that give returns too far into the future.
• It is particularly useful for businesses where liquidity is of greater significance than overall Probability

Question 9

Disadvantages of Payback:

Answer 9

• It does not measure the overall profitability of a project.
• This concentration on the short term may lead businesses to reject very profitable investments just because they take some time to repay the capital.
• It does not consider the timing of the cash flows during the payback period.

Question 10

Accounting rate of return (ARR)

Answer 10

Measures the annual profitability of an investment as a percentage of the average investment (average capital cost

-ARR = average annual profit / average investment x 100

-Where the average investment = (initial capital cost + residual capital value)/2

Question 11

Why is ARR important:

Answer 11

It shows the expected annual return of the investment which can be compared with:

-The ARR of other projects

-Minimum expected return set by the business called criterion rate.

-The annual interest rate of loans. If the ARR is lower than the interest it will not be worthwhile taking a loan to invest in the project

Question 12

Advantages of ARR

Answer 12

• It uses all of the cash flows, unlike the payback method.
• It focuses on profitability, which is the central objective of many business decisions.
• The result is easily understood and easy to compare with other projects that may be competing for the limited investment funds
  available.
• The result can be quickly assessed against the predetermined criterion rate of the business.

Question 13

Disadvantages of ARR

Answer 13

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