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IB Business Management - HA > Investment Appraisal > Flashcards

Investment Appraisal Flashcards

1
Q

What is an investment ?

A

the purchase of an asset with the potential to yield future returns.

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2
Q

What is Investment Appraisal?

A

The quantitative techniques used to calculate the financial costs and benefits of an investment decision.

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3
Q

Methods of Investment Appraisal

A

Payback Period
Accounting Rate of Returns (ARR)
Net Present Value

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4
Q

Payback Appraisal

A

The period of time for an investment project to earn enough profits to repay the cost of the initial investment.

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5
Q

PA Formula

A

Payback Period = Initial Investment / Contribution per month
or
= Initial Investment / (Contribution per year/12)

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6
Q

When the profits are not the same each year for Payback Period

A

Use the cumulative cash flow method.
eg. Initial investment = $950
Cash Flow Cash Flow
Normal: Year 1 $500 Year 2 $500
Cumulative : Year 1 $500 Year 2 $1000
Payback after year 1 :$950 - $500 = $450
Cash flow per month for year 2 : $500/ 12= $41.67
Number of months : $450/ $41.67 = 10.8 months
Therefore PA= 1 year and 10.8 months

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7
Q

Uses of Payback Period Calculations

A

Managers can use the payback period for one investment with another and compare by ranking in order

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8
Q

Uses of Payback Period Calculations

A

Businesses may have a “cut-off” period for payback and decided whether the investment is favorable

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9
Q

Advantage of PBP : Calculation

A

It is quick and easy to calculate

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10
Q

Disadvantage PBP: Opportunity

A

If business’ focus is on the payback period, they may not invest in a good opportunity.

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11
Q

Advantage PBP : Understanding

A

Results easily understood by managers

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12
Q

Advantage PBP : Speed of Return

A

The emphasis on speed of return of cash flows gives the benefit of concentrating on the more accurate short-term forecasts of the project’s profitability.

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13
Q

Advantage PBP: Late returns

A

The results eliminates projects that would deliver returns too late in the future

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14
Q

Advantage PBP: Liquidity

A

It is particularly useful for businesses where liquidity is of greater significance than overall profitability.

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15
Q

Disadvantage PBP: Profitability

A

It does not measure the overall profitability of a project – indeed, it ignores all of the cash flows after the payback period. It may be possible for an investment to give a really rapid return of capital but then to offer no other cash inflows.

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16
Q

Problems with Payback Period : Interest

A

A business may have borrowed the finance for the investment and along payback period will increase interest payments.
If capital is not a loan, the opportunity cost, money that could be used in other investments are seized.

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17
Q

Concept : Speed

A

The speedier the payback, the more quickly the capital is made available for other projects.

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18
Q

Concept: Time

A

Cash Flows in the future have less real value than cash flows today due to inflation. The more quickly repaid the more the real value will be.

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19
Q

Concept: Time with managers

A

Some managers are ‘risk-averse’– they want to reduce risk to a minimum so a quick payback reduces uncertainties for these managers. Cash flows in the future have less certainty that current ones. (real value lessens)

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20
Q

Quantitative Investment Appraisal Requirements: Capital

A

Initial capital cost of the investment including all installation costs

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21
Q

Quantitative Investment Appraisal Requirements: Expectancy

A

The estimated life expectancy of the investment- how long can returns be received from investment

22
Q

Quantitative Investment Appraisal Requirements: Residual Value

A

After the assets are no longer needed, can they be sold for more money?

23
Q

Quantitative Investment Appraisal Requirements: Forecasted Net Returns

A

Are the returns of the investment greater than the annual running cost? (investment- cost of running )

24
Q

Average Rate of Return(ARR) definition

A

Measures the annual profitability of of an investment as a percentage of the initial investment.

25
Q

ARR formula

A

(Total profit product’s life span ÷ number of years of the project / Initial amount invested ) x 100

26
Q

ARR expression

A

expressed as a percentage

27
Q

ARR use

A

allows managers to compare the rates of return with other projects

28
Q

Criterion Rate of ARR

A

The minimum rate of return that managers desire on an investment

29
Q

Rate of ARR vs. interest rate

A

If interest rate is equal to or less than the ARR rate then the investment is not worth risking.

30
Q

Annual forecasted net cash Flow =

A

forecasted cash inflow - forecasted cash outflow

31
Q

Factors the affect Forecasts

A

External Factors that affect forecasts of investment appraisal that reduce accuracy

  • Possible economic recession, returns may be less and the dollar may devalue increasing payback period
  • Costs may increase for raw materials for investment
32
Q

When is the investment made?

A

year zero (0) and is a bracketed amount as it is a cost

33
Q

Long pay back period

A

Increase Payments due to inflation

34
Q

Advantages of ARR: Cash Flow

A

Uses all the cash flows unlike payback method

35
Q

Advantages of ARR: Profitability

A

Focuses on profitability which is the main pivotal point that managers used to make decisions.

36
Q

Advantages of ARR: Comparison

A

Easy to understand results and use them to compare with other investment projects especially if their is limited investment funds available

37
Q

Advantages of ARR: Criterion Rate

A

Results may be easily measured against the criterion rate for quick analysis

38
Q

Disadvantages of ARR: Time Payback

A

It ignores the time that the cash flows will come and two projects may have similar ARR but the time in which the cash flow may come are different.

39
Q

Disadvantages of ARR: Cash Flow Included

A

Since all cash flows are included then the later cash flows that as less likely would give inaccurate results.

40
Q

Disadvantages of ARR: Time Value of Money

A

The time value of money is ignored therefore all after subtractions are not accounted for.

41
Q

Reason for using Discounted Cash Flow

A

Money in present time will be worth less later. Hence the ARR and PBP methods are not reliable to make a favorable decision

42
Q

Reason for getting cash sooner than later

A
  • It can be spent immediately and the benefits may be reaped immediately . No waiting involved
  • Cash today is certain but future money always has uncertainty
  • therefore the time value of money is taken into consideration in NPV
43
Q

Variables used for NPV

A

interest rates and time
- the longer into the future and the higher the interest rate the less the real value of money. ( if raised internally then opportunity costs play an impact)

44
Q

HOW TO CALCULATE NPV

A
  1. Multiply discount factors by the net cash flows for each year however , year 0 is not discounted
  2. Add the discount cash flows for each year (total present value)
  3. Total Present Value - Initial Investment cost
    - if NPV is positive then it is profitable
45
Q

Advantages of NPV : Timing

A

Considers timing of cash flow and their size

46
Q

Advantages of NPV : Rate of Discount

A

Rate of discount could be varied to include different economic circumstances

47
Q

Advantages of NPV : Time value

A

Takes into consideration the time value for money and the opportunity cost

48
Q

Disadvantage of NPV : Explainable

A

Reasonably complex to calculate and explain

49
Q

Disadvantage of NPV : Rates used

A

The results rely on the rates used and these may be wrong leading to inaccurate results if expectations are incorrect.

50
Q

Disadvantage of NPV :

A

NPV can be compared with other projects only if the initial investment costs are the same because NPV does not give a percentage rate of return on the investment

IB Business Management - HA (2 decks)

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