Investment appraisal 3.3.2

Question 1

What is capital expenditure?

Answer 1

The main distinction is that capital expenditure is non-current assets which have an economic life in the business – they are intended to be kept, rather than sold or turned into products.

Question 2

What are the main reasons for capital expenditure?

Answer 2

• To add extra production capacity.
• To replace worn-out, broken or obsolete machinery and equipment.
• To support the introduction of new products and production processes.
• To implement improved IT systems.
• To comply with changing legislation and regulations.

Question 3

What is investment?

Answer 3

Process of using the money for future profits or material growth.

Question 4

What is investment appraisal?

Answer 4

The process of analysing whether investment projects are worthwhile.

Question 5

What are the factors affecting a decision?

Answer 5

• Risk
• Return
• Motive
• External factors

Question 6

What are the 3 methods businesses use to help determine the time to make a return and how much profit?

Answer 6

• Calculating payback period
• Calculating average rate of return
• Discounted cash flows (net present value)
• Internal rate of return

Question 7

What are the benefits of investment appraisal methods?

Answer 7

• Show how much money they’ll make
• When it will make this money
• How much will be spent
• When will the money be needed

Question 8

What are the drawbacks of investment appraisal methods?

Answer 8

• Only as good as the data used to calculate
• Any incorrect predictions will mean the calculations will be wrong
• False data - estimated profits and cash flows can be easily overstated.
• Could result in false information and inform the business to make the wrong decision
• Investment size - the more of the available funds are used, the riskier the project gets.
• Changing environment - economics and markets constantly change and therefore, the stated data may become inaccurate.

Question 9

What is payback?

Answer 9

How long do we have to wait until the cash flows equal or exceed the initial cost of the investment?

Question 10

How to calculate the payback period?

Answer 10

Payback Period = Initial investment / Cash flow per year

Question 11

What are the benefits of the Payback method of the appraisal?

Answer 11

• Simple and easy to calculate + easy to understand the results.
• Focuses on cash- which is normally scarce.
• Emphasises speed of return; good for markets which change rapidly.
• Straightforward to compare competing projects.

Question 12

What are the drawbacks of the Payback method of the appraisal?

Answer 12

• Ignores the cash flows after the payback period has been reached. i.e doesn’t look at the overall project return.
• Takes no account of the “time value of money”.
• May encourage short-term thinking.
• Does not actually create a decision for the investment.

Question 13

What is the average rate of return (ARR)?

Answer 13

The average rate of return method looks at the total accounting return for a project to see if it meets the target return.

Question 14

How to calculate the average rate of return?

Answer 14

1. total cash inflows
2. total cash inflows - the cost of investment = profit
3. Average annual profit = profit / life of investment
4. ARR = net return per annum (p.a) (average) / cost of investment

Question 15

What are the benefits of ARR?

Answer 15

• ARR provides a percentage return which can be compared with a target return.
• ARR looks at the whole profitability of the project.
• Focuses on profitability > key issue for shareholders.
• The only method that uses the concept of profit.

Question 16

What are the drawbacks of ARR?

Answer 16

• Does not take into account when cash flow occurs > only the profit p.a.
• Takes no account of the time value of money.
• Treats profits arising late in the project in the same way as those which might arise early > company may not be able to survive in the short term.

Question 17

What is discounted cash flow (net present value)?

Answer 17

• Calculates the monetary value of the project’s future cash flows.
• NPV= the discounted cash inflow minus the initial cost of the investment.
• If NPV is positive, the project will be considered profitable and worthwhile.
• If NPV is negative, the project is considered unprofitable and will be rejected.

Question 18

How to calculate the discounted cash flow (NPV)?

Answer 18

1. Multiply net cash flow x discount factor.
2. Add up all the present values.
3. Substrate the initial outlay.

Question 19

What is the equation to calculate the present value of a future cash flow?

Answer 19

Cash flow x discount factor= present value

Question 20

What are the benefits of NPV?

Answer 20

• Takes into account the time value of money, placing emphasis on earlier cash flows.
• Looks at all the cash flows involved throughout the life of the project.
• Use of discounting reduces the impact of long-term, less likely cash flows.
• Has a decision-making mechanism-reject projects with negative NPV.

Question 21

What are the drawbacks of NPV?

Answer 21

• More complicated method – users may find it hard to understand.
• Difficult to select the most appropriate discount rate – may lead to good projects being rejected.
• The NPV calculation is very sensitive to the initial investment cost.

Question 22

What are the risks and uncertainties in investment appraisal?

Answer 22

• Length of the project: The longer the project, the greater the risk that estimated revenues, cost and cash flows prove unrealistic.
• Source of the data: Estimated project profit in cash flow based on detailed research, gut feel, or a little of both.
• Size of the investment: An investment that uses most of the available business funds is, by definition, riskier than a smaller project. Risk is also about the consequences to the business if something goes wrong.
• Economic and market environment: A major issue for large investments. Most projects will make assumptions about demand come across, pricing etc which can become widely inaccurate through changing market and economic conditions.
• Experiences of the management team: A project in a market in which the management team has strong experience is a low-risk proposition than one in which the business is taking a step into the unknown.

Question 23

What are qualitative factors that have an influence on investment appraisal?

Answer 23

• The impact on employees.
• Product quality and customer service.
• Consistency of the investment decision with corporate objectives.
• The business’s brand and image, including reputation.
• Implications for operations, including any disruption or change to the existing set up.
• Responsibilities to society and other external stakeholders.

Question 24

What are the quantitative influences on investment appraisal?

Answer 24

• A problem with the three main investment appraisal methods is that they can generate seemingly contradictory results. For example, an investment might have a long payback period because the returns only occur several years into the project (possibly too long to be acceptable). However, if those returns are significant to the original investment, it is likely that the NPV or ARR would suggest going ahead.
• The use of investment criteria is intended to help guide management through these decisions and address the potential conflicts.
• So possible criteria might suggest only accepting investment proposals which meet at least two of the following:

A payback within four years
ARR of at least 20%, with no profits taken into account beyond Year 5
NPV of at least 25% of the initial investment