Investment appraisal

Question 1

Define the term investment appraisal.

Answer 1

Investment appraisal attempts to determine the value of capital expenditure projects. It enables the business and its investors to compare projects so that the business can expand and meet their objectives – usually profit maximisation and efficiency.

Question 2

Explain investment appraisal as a planning process.

Answer 2

Investment appraisal is the planning process used to determine whether the long term investments will give the best return.

Projects such as;
new machinery
new premises
research and development projects

Question 3

Explain how investment appraisal aids decision making.

Answer 3

A business will have lots of ideas for projects, and proposals of ways to grow their business. The business will only have a finite amount of money and so perhaps only one project will get the funding it needs to go ahead. Investment appraisal is used to work out which project should get the funds.

Question 4

How do you calculate project payback?

Answer 4

Year 0 is the investment. You find which year it is paid back in.

If it’s half way through a year, you add the years before and find the difference left to be paid back.

Divide the amount left to be paid by the total amount made that year and multiply the whole thing by twelve. This will be the number of months it will take on top of the previous number of years.

Question 5

How do you calculate average rate of return?

Answer 5

1. Add up all the cash inflows from years
2. Then minus the original cost of the project
3. Then divide this by the number of years the project runs for
4. Now take this figure and divide it by the cost of the project and multiply by 100 to produce a percentage.

Question 6

What is net present value?

Answer 6

it takes into account that money in the future is not worth what it is today – so it adds in a discount table to make it more realistic

Question 7

How do you calculate net present value?

Answer 7

You will be given the discount table.

Multiply each cash inflow by the discount, this gives the present value column

NPV is all the NPV values added together then minus the initial cost

Question 8

What are the limitations of investment appraisal?

Answer 8

Payback limitations; very simple, only looks at speed of payback and does not look at profitability

ARR limitations; Does not take into account the effects of time on the value of money

NPV limitations; Very complex, not used by small business, also results dependent on rate of discount used, the higher the rate the more likely it is that the project will be rejected as unprofitable