Investment Appraisal

Question 1

Investment appraisal definition

Answer 1

The process of analysing whether investment projects are worthwhile

Question 2

Payback period meaning

Answer 2

The time it takes for a project to repay its initial investment

Question 3

Steps for payback period

Answer 3

1. Find the net cash flow for all years given (identify)
2. Add net cash flows per year until reaching or close to initial cost amount
   3.find the difference between the cost and the current sum of numbers
   4.use newly calculated number and divide by the net cash flow of that year the cost would be gained back
3. Times number by 12
4. Add years plus months

Question 4

Benefits of payback period (4)

Answer 4

-simple and easy to calculate
-easy to understand results
-focuses on cash flow
-emphasises speed of return; good for markets which change rapidly

Question 5

Drawbacks of payback (5)

Answer 5

-ignores cash flows after payback has been reached
-takes no account of the “time value of money”
-may encourage short term thinking
-ignores qualitative aspects of decision making
-does not actually create a decision for the investment

Question 6

What are the 3 main methods of investment appraisal

Answer 6

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

Question 7

ARR definition

Answer 7

Looks at the total accounting return for a project to see if it needs the target return

Question 8

ARR formula

Answer 8

1. Add up inflows of years
2. Then minute original cost of the project
3. Divide this by the number of years the project runs for
4. Take this figure and divide it by the cost of the project (finding percentage and comparing)

Question 9

Benefits of ARR (3)

Answer 9

-simple to understand + easy to calculate
-focuses on the overall profitability
-easy to compare with ARR with other investment appraisals

Question 10

Disadvantages of ARR (3)

Answer 10

-ignores timings of return
-focuses on profits rather than cash flows
-doesn’t adjust for the time value of money

Question 11

NPV definition

Answer 11

net present value, calculated the monetary value now of the projects future cash flows

Question 12

Discounting meaning

Answer 12

The meeting his used to reduce the future value of cash flows to reflect the risk that they may not happen

Question 13

NPV formula

Answer 13

Future cash flow x discount factor = NPV

Question 14

NPV advantages (2)

Answer 14

-time value of money
-decision making

Question 15

NPV disadvantages (3)

Answer 15

-can’t be used to compare projects of different sizes
-hidden costs
-not set guidelines to calculate required rate of return