Investment Appraisal

Question 1

Define Investment Appraisal

Answer 1

A process used to determine whether funds given to a business for investment are likely to be profitable.

Question 2

What are the methods of investment appraisal

Answer 2

ARR (average rate return
Payback rate
NPV (net present value)

Question 3

What is the purpose of investment appraisal

Answer 3

The purpose of investment appraisal is to evaluate the attractiveness of possible investment in quantifiable terms so as to lower the risk in taking an appropriate course of action

Question 4

Define Payback

Answer 4

Refers to the amount of time it takes for a business to recover the initial amount invested, sometimes termed “payback period

Question 5

What is the formula for payback period

Answer 5

Amount required/net cash flow in years x12

Question 6

Evaluate payback period method

Answer 6

• Easy to calculate and simple to use.
• Effective to use when technology is changing at a fast
  rate in order to recover the cost of investment as quickly as possible
• Considers timings of cash flows

Disadvantages:

• Ignores what happens after the payback period.
• May encourage a short-term attitude.
• Ignores total profitability, the focus is just on the speed to which the initial outlay is repaid.

Question 7

What is the formula for average rate of return

Answer 7

Average rate of return = net profit / cost x 100

Remember to divide the net profit by the amount of years the project runs for

Question 8

Define average rate of return

Answer 8

Measures the net return each year as a percentage of the capital cost of the investment

Question 9

Evaluate average rate of return

Answer 9

Advantages

• Uses all the cash flows over life of the project.
• Focuses on profitability.
• Easy to make comparisons (compare % returns on different investments).

Disadvantages

Ignores timings of the cash flows.

Does not allow for effects of inflation on values of future cash flows.

Question 10

Define net present value

Answer 10

Net Present Value (NPV) is used to evaluate the profitability of an investment by comparing the present value of its expected cash flows to the initial investment cost.

Question 11

Formula for NPV

Answer 11

Take the amount of years, then find the cash flow for those years and times the cash flow by the discount factor, add all the discounted values together and minus by the original cost.

Amount of years | Cash flow x discount factor =

all discounted values – original cost = NPV

Question 12

Evaluate NPV

Answer 12

Advantages:

• Easy to compare different projects.
• Allows for impact of inflation on value of future cash flows.
• Discounts can be changed for changes in the economic climate.

Disadvantages:

• Complex to calculate.
• Discount factors could be incorrect which makes the NPV inaccurate.
• Difficult to set discount factors far into the future

Question 13

Evaluate the viability of investment appraisal

Answer 13

They generally give a good insight whether an investment is worthwhile or not

All use cash-flow forecasts, which may be inaccurate and affect the reliability

The risk and uncertainty need to be taken into account also.