Investment Appraisal (3.3.2)

Question 1

What is meant by the term investment appraisal?

Answer 1

Using cash flow forecasts to assess the financial attractiveness of an investment decision

Question 2

What are the three methods of Investment Apprasial?

Answer 2

-Payback period
-Average Rate of Return
-Net Present Value

Question 3

What is the Payback Period?

Answer 3

Focuses on how long it will take to get our money back. This is done using a Cash flow forecast.

Question 4

What’s the formula for Payback Period?

Answer 4

Sum Investment/ Net Cash Per Time Period

Question 5

What formula do you use for payback period if cash flows aren’t consistent over time?

Answer 5

Remaining balance/ Monthly cash in year of payback

Question 6

What does the payback period being short mean?

Answer 6

The quicker the pp, the less time your investment is at risk

Question 7

What are the Advantages of Payback?

Answer 7

-Easy to calculate and interpret
-May be more accurate as it ignores longer-term forecasts
-Takes into account the timings of cash flow
-Important for businesses with poor cash flow to reduce the risk of longer investments

Question 8

What are the Disadvantages of Payback?

Answer 8

-Provides no information on profitability
-Ignores what happens after the payback
-May become too short-sighted
-More beneficial used alongside ARR or NPV

Question 9

What is Average Rate of Return (ARR)?

Answer 9

-Compares the average annual profit generated by an investment with the amount invested
-This can then be compared against other investments

Question 10

What are the three steps to calculating ARR?

Answer 10

1. Total Net Cash Flow- Initial Investment=Investment Profit
2. Investment Profit/ Years of Investment=Average Annual Profit
   3.(Average Annual Profit/ Investment Outlay) x100=ARR

Question 11

Is it better if the ARR is high or low?

Answer 11

The higher the ARR the better. Unless the investment has another object. The higher ARR tends to be the one the firm invests in.

Question 12

What are the Advantages of ARR?

Answer 12

-Use all cash flows over the years of investment
-Focuses on the profitability
-Easy to compare % returns against other investment opportunities to make a decision

Question 13

What are the Disadvantages of ARR?

Answer 13

-Later years hard to predict making results less accurate than payback
-Ignores the timing of cash flows
-Ignores the time value and opportunity cost of the money invested

Question 14

Are ARR and Payback Period better used together or separately?

Answer 14

These two techniques work best when used together

Question 15

What is Net Present Value (NPV)?

Answer 15

-Calculates future cash flows with a discount factor applied to remove potential Opportunity costs
-Assess and investment against other investments such as a savings account

Question 16

Is it better for NPV to be higher or lower?

Answer 16

Higher the NPV the more profitable the investment is. Positive NPV shows investment will give a greater return than other opportunities.

Question 17

What will investment decisions depend on?

Answer 17

-The capabilities of the business
-Predicting the future landscape of the business

Question 18

What are some of the capabilities of the business that investment decisions will be made from?

Answer 18

-Length of the project
-Finance available to a business
-Motivation and quality of staff
-Capacity Utilization
-Corporate objectives
-response from stakeholders

Question 19

What are the limitations of Predicting future sales in an investment appraisal?

Answer 19

Can’t predict many things that could happen in the future and many things limit our ability to do so.

Question 20

What are some real-life examples of things we cant predict that could affect future sales?

Answer 20

-Future state of the economy
-Reaction of competitors to our investments
-Whether our past sales data will continue
-Whether there will be any changes in legislayion
-If the Staff will be happy with the decision