Investment Appraisal

Question 1

What is an investment ?

Answer 1

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

Question 2

What is Investment Appraisal?

Answer 2

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

Question 3

Methods of Investment Appraisal

Answer 3

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

Question 4

Payback Appraisal

Answer 4

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

Question 5

PA Formula

Answer 5

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

Question 6

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

Answer 6

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

Question 7

Uses of Payback Period Calculations

Answer 7

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

Question 8

Uses of Payback Period Calculations

Answer 8

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

Question 9

Advantage of PBP : Calculation

Answer 9

It is quick and easy to calculate

Question 10

Disadvantage PBP: Opportunity

Answer 10

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

Question 11

Advantage PBP : Understanding

Answer 11

Results easily understood by managers

Question 12

Advantage PBP : Speed of Return

Answer 12

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.

Question 13

Advantage PBP: Late returns

Answer 13

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

Question 14

Advantage PBP: Liquidity

Answer 14

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

Question 15

Disadvantage PBP: Profitability

Answer 15

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.

Question 16

Problems with Payback Period : Interest

Answer 16

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.

Question 17

Concept : Speed

Answer 17

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

Question 18

Concept: Time

Answer 18

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.

Question 19

Concept: Time with managers

Answer 19

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)

Question 20

Quantitative Investment Appraisal Requirements: Capital

Answer 20

Initial capital cost of the investment including all installation costs

Question 21

Quantitative Investment Appraisal Requirements: Expectancy

Answer 21

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

Question 22

Quantitative Investment Appraisal Requirements: Residual Value

Answer 22

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

Question 23

Quantitative Investment Appraisal Requirements: Forecasted Net Returns

Answer 23

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

Question 24

Average Rate of Return(ARR) definition

Answer 24

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

Question 25

ARR formula

Answer 25

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

Question 26

ARR expression

Answer 26

expressed as a percentage

Question 27

ARR use

Answer 27

allows managers to compare the rates of return with other projects

Question 28

Criterion Rate of ARR

Answer 28

The minimum rate of return that managers desire on an investment

Question 29

Rate of ARR vs. interest rate

Answer 29

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

Question 30

Annual forecasted net cash Flow =

Answer 30

forecasted cash inflow - forecasted cash outflow

Question 31

Factors the affect Forecasts

Answer 31

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

Question 32

When is the investment made?

Answer 32

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

Question 33

Long pay back period

Answer 33

Increase Payments due to inflation

Question 34

Advantages of ARR: Cash Flow

Answer 34

Uses all the cash flows unlike payback method

Question 35

Advantages of ARR: Profitability

Answer 35

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

Question 36

Advantages of ARR: Comparison

Answer 36

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

Question 37

Advantages of ARR: Criterion Rate

Answer 37

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

Question 38

Disadvantages of ARR: Time Payback

Answer 38

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.

Question 39

Disadvantages of ARR: Cash Flow Included

Answer 39

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

Question 40

Disadvantages of ARR: Time Value of Money

Answer 40

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

Question 41

Reason for using Discounted Cash Flow

Answer 41

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

Question 42

Reason for getting cash sooner than later

Answer 42

- 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

Question 43

Variables used for NPV

Answer 43

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)

Question 44

HOW TO CALCULATE NPV

Answer 44

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

Question 45

Advantages of NPV : Timing

Answer 45

Considers timing of cash flow and their size

Question 46

Advantages of NPV : Rate of Discount

Answer 46

Rate of discount could be varied to include different economic circumstances

Question 47

Advantages of NPV : Time value

Answer 47

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

Question 48

Disadvantage of NPV : Explainable

Answer 48

Reasonably complex to calculate and explain

Question 49

Disadvantage of NPV : Rates used

Answer 49

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

Question 50

Disadvantage of NPV :

Answer 50

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