Investment Appraisal

Question 1

Simple interest formula

Answer 1

S = P + nrP

Question 2

Reasons to look at cash flow rather than profit in appraising investment

Answer 2

• Cash flow is crucial for organisation
• Time value of money is considered
• More objective figure (not susceptible to interpretation)
• Better long-term indication of value

Question 3

Assumptions of NPV method

Answer 3

• All cash flows occur at the year’s start or end
• The initial investment happens at Year 0 (today)
• All the other cash flows take place in Year 1 or late

Question 4

Advantages of NPV

Answer 4

• Considers time value of money
• Absolute measure of return, presented in monetary terms
• Uses cash flow rather than profit
• Considers the whole life of investment

Question 5

Disadvantages of NPV

Answer 5

• Complicated for non-financial manager to understand
• Relies on judgment regarding the discount rate used

Question 6

Rule to accept/reject project with IRR

Answer 6

IRR > Cost of Capital

–> Accepted

Question 7

Advantages of IRR Method

Answer 7

• Considers the time value of money
• Uses cash flow
• Easy for non-financial manager to compare against a target %

Question 8

Disadvantages of IRR Method

Answer 8

• Ignore the size of the project
• Decision may conflict with NPV
  (** NPV is always superior method !!!)
• For non-conventional investments (where multiple investments are needed throughout the project’s life), There may be more than one solution for IRR

Question 9

Simple Payback period formula

(assume annual cash inflow is constant)

Answer 9

= Initial investment / yearly cash flow

Question 10

Advantages of payback period method

Answer 10

• Simple to calculate
• Outcome is easy to understand for non-financial managers
• Helps organisations with cash flow problems identify which projects will return the investment early

Question 11

Disadvantages of payback period

Answer 11

• Does not consider the time value of money
• Does not consider the cash flows that take place after the payback period (may underestimate the value of the project)
• Does not work well if there are costs later in the project
• Encourages decisions to be made on short-term factors rather than the long-term benefit to the organisation