Investment Appraisal (AL)

Question 1

Investment appraisal

Answer 1

Evaluating the profitability or feasibility of an investment project

Question 2

Info required before appraising profitability of an investment

Answer 2

-Initial capital cost
-Estimated life expectancy of the asset
-Residual value of investment
-Forecasted net cash flows from project

Question 3

Payback period

Answer 3

Time taken for net cash inflows to pay back the original capital cost of investment

Question 4

Benefits and limitations

Answer 4

Benefits
-Quick and easy to calc
-Results are easily understood by managers
-Particularly useful for businesses where liquidity is of greater significance than profitability

Limitations
-Does not measure profitability (ignores all cashflows after payback period)
-Concentrates on short term ,which leads to rejection of long term profitable investments
-Does not consider the timing of cashflows during payback period

Question 5

Accounting rate of return (ARR)

Answer 5

avg annual profit
————————— X 100
avg investment

-Measure the annual profitability as a percentage of the avg investment

Question 6

Benefits and limitations of ARR

Answer 6

Benefits
-Uses all cashflows unlike payback
-Focuses on profitability, which is central objective of many businesses
-Result is easily understood and comparable with other projects competing for investment funds

Limitations
-Ignores timing of cashflows, this may result in two projects having similar ARR results
-As all cash inflows are included, future cashflows calculated are less likely to be accurate
-Time value of money is ignored as cashflows have not been discounted

Question 7

Discounted cashflow

Answer 7

The present day clue of a future cashflow

Question 8

Net present value (NPV)

Answer 8

Todays value of the estimated cash flow resulting from investment

Question 9

Calc NPV

Answer 9

1) Multiply discounted factors and net cashflow
2)Add the discounted cashflows
3)Subtract the capital cost to give NPV

Question 10

Benefits and limitations of NPV

Answer 10

Benefits
-It considers both timing of cash flows and size of them
-Rate of discount can vary for different economic circumstance
-It considers the time value of money and takes into account cost of money

Limitations
-Reasonably complex to calculate and explain to non numerate mangers
-Final result depends on rate of discount used and not expectations on interest rates
-NPV’s can be compared to other projects only if initial capital cost is the same

Question 11

Qualitative factors and their impact on investment decisions

Answer 11

-Impact on environment and local community
-Refusal of planning permission
-Aims and objectives of the business
-Impact on workforce
-Acceptability of risk