Investment appraisal

Question 1

In which ways may a business invest?

Answer 1

• By releasing a new product
• By expanding into new markets
• By considering new strategies to help build market share
• By expanding production capacity
• By developing new technology

Question 2

Define INVESTMENTS

Answer 2

Investments are strategic decisions with long term consequences - anything that costs a business but will eventually result in a benefit.

Question 3

Define INVESTMENT APPRAISAL TECHNIQUES

Answer 3

Investment appraisal techniques are techniques that allow a business to assess the forecast financial returns of an investment or make comparisons between investment projects.

Question 4

Define PAYBACK PERIOD

Answer 4

Payback period is the time it takes for a project to repay its initial investment outlay.

Question 5

What is the method used for calculating payback?

Answer 5

1. Look at the year in which payback is finally achieved. The final answer will be this amount of years + ? months.
2. Take the amount still required at the start of the year of payback and divide by the net cash flow for that year.
3. Times the answer by 12 to get the months.

Question 6

What are the advantages of using payback?

Answer 6

• Focuses on cash, which is important in businesses who have weak cash flow.
• Emphasises the speed of return - important in dynamic markets.

Question 7

What are the limitations of payback?

Answer 7

• Doesn’t look at overall profits, only those that arise until payback has been achieved.
• May lead to short-termism,
• Ignores qualitative factors.

Question 8

Define AVERAGE (ACCOUNTING) RATE OF RETURN

Answer 8

ARR measures the overall profitability of an investment as a percentage of the initial investment cost.

Question 9

What is the method used for calculating ARR?

Answer 9

1. Add up the total forecasted return for all the years (excluding year 0)
2. Deduct the initial cost.
3. Divide by the lifespan of the project.
4. Use (ARR/initial costs) x 100 to find the final percentage.

Question 10

How can firms use payback?

Answer 10

• They can set upper limits on the time it takes to payback

- Projects can be ranked depending on how long they take to payback.

Question 11

How can firms use ARR?

Answer 11

• A predetermined level can be set, with projects not meet that level of ARR.
• When faced with alternative projects, their respective ARRs can be compared.

Question 12

What are the advantages of using ARR?

Answer 12

• Has links with corporate objectives as it involves profitability.
• Considers returns over the whole life of the project
• Easy to compare with business objectives

Question 13

What are the limitations of ARR?

Answer 13

• Treats profits arising early the same as profits arising late
• The cash inflows and outflows on which it is based may be less reliable
• The business may start to prioritise quick returns over long term profitability (short termism)

Question 14

Define PRESENT VALUE

Answer 14

Present value is what money in the future is worth now, taking into consideration things like interest rates and inflation.

Question 15

How is NPV calculated?

Answer 15

1. List the net cash flows for the life of the project.
2. Multiply discount factors by the net cash flows
3. Add all the NPVs together
4. Minus the initial cost to get the net value.

Question 16

How can firms use NPV?

Answer 16

• They can rank projects depending on which one has the highest NPV
• They can choose to select all projects that meet the cut off criteria or with a positive net value.

Question 17

What are the advantages of using NPV?

Answer 17

• Takes into account the time value of money
• Looks at all cash inflows throughout the life of the project
• Use of discounting reduces the impact of long term, less likely cash flows
• Has a clear decision making mechanism

Question 18

What are the limitations of NPV?

Answer 18

• Complicated process
• Difficult to select the most appropriate discount rate
• The NPV calculation is very sensitive to the initial investment cost