Investment appraisal techniques (11)

Question 1

Define the payback period

Answer 1

The payback period is the time required to recover the initial investment

Question 2

State the formula for payback period

Answer 2

Payback period = initial payment/annual cash flow

Question 3

State the two formula to calculate the accounting rate of return

Answer 3

ARR (initial) = average annual profit/initial investment x 100

ARR (average) = average annual profit/average investment x 100

where average investment is 1/2(initial investment + final/scrap value)

Question 4

State the formula for calculating terminal value

Answer 4

Terminal value = X (1+r)^n
where x = amount invested
r = interest rate
n = number of years

Question 5

State the formula for discounting to present value

Answer 5

Present value = X(1/(1+r)^n)

Question 6

Define an annuity

Answer 6

An annuity is a constant annual cash flow for a number of years. The present value can be found using an annuity formula or annuity tables.

The annuity factor is the name given to the sum of the individual discount factors.

Question 7

State the formula for present value of an annuity

Answer 7

Present value = annuity x annuity factor

where AF = 1/r(1-(1/(1+r)^n))

Question 8

Define a perpetuity

Answer 8

A perpetuity is an annual cash flow that occurs forever. It is often described by examiners as a cash flow continuing ‘for the foreseeable future’

Question 9

State the formula for present value of a perpetuity

Answer 9

Present value = cashflow/ r

or PV = cashflow x 1/r