Investment appraisals and special orders

Question 1

What is an investment appraisal?

Answer 1

=a process to determine whether a planned investment is the right decision. Large amounts of money are involved in the hopes of generating a profit, meaning investments have risk.

Question 2

What is the purpose of an investment appraisal?

Answer 2

-Quantify the attractiveness/risk of an investment.
-Assess the general feasibility of a project.
-Consider alternative projects.
-Reveal the level of investment required for success.

Question 3

What is payback period?

Answer 3

The amount of time it takes for a business to recover the initial amount invested.

Question 4

How do you calculate payback period?

Answer 4

Sum of capital invested / net cash income = payback period.
Calculate the cumulative cash flow, then see which year it will be paid back. Work out which month it will be paid back in. After this point, profit will be made from the investment.

Question 5

Advantages of payback period?

Answer 5

simple to use and easy to determine, focuses on cash which is important to everyday running of the business, straightforward to compare options, helps to manage cash flow.

Question 6

Disadvantages of payback period?

Answer 6

encourages short term thinking about investment, far ahead predictions that may not be accurate, ignores qualitative aspects, ignores cash flow after payback period, ignores total profitability.

Question 7

What is average rate of return?

Answer 7

Measures the average net return every year expressed as a percentage of the cost of investment.

Question 8

How to calculate average rate of returns?

Answer 8

ARR= average annual profit / cost of investment. X100.
Calculate total income, subtract the cost, divide by the years. This is the annual average profit.

Question 9

Advantages of ARR?

Answer 9

includes all the project’s cash flows, focuses on profitability, easy to compare projects and the cost of borrowing.

Question 10

Disadvantages of ARR?

Answer 10

projected cash flows may prove to be inaccurate, ignores the timings of cash flow, ignores the opportunity cost aspect because not taking into account the time, does not allow for inflation/changes in valuation of cash flow.

Question 11

What is discounted cash flow?

Answer 11

Takes into account the time value of money (the realisation that the value of money changes over time). The discounted cash flow method calculates the net present value (NPV) of alternative options/projects.

Question 12

What is net present value?

Answer 12

the value of future money if you had it now.

Question 13

How to calculate discounted cash flow?

Answer 13

Multiple each income by the discount factor for that year, add all these together for the total present value. Subtract the cost for the net present value.
It is possible to end up with a negative NPV. Businesses should only invest in positive NPVs.

Question 14

Advantages of discounted cash flow?

Answer 14

takes into account devaluation of money, Takes into account timings of cash flow, can be used to consider different investment scenarios in terms of interest rates.

Question 15

Disadvantages of discounted cash flow?

Answer 15

complex calculation, results can be misunderstood, projects can only be compared if the initial investment is the same, estimated discount factors.

Question 16

Problems with quantitative investment appraisals?

Answer 16

All three quantitative methods are based on cash flow forecasts which may be inaccurate. The more long-term, the greater the risk.

Question 17

What qualitative factors need to be considered?

Answer 17

Qualitative factors that need to be considered are corporate objectives, financial position, social and ethical responsibilities, impact on staff, competitor actions and confidence of managers.

Question 18

What is a special order?

Answer 18

a one-time order that is not considered part of the company’s normal ongoing business

Question 19

How do you decide whether or not to accept a special order?

Answer 19

The decision to accept/reject the order depends upon the potential benefits. A key issue is whether the cost of production will be met, and this depends on the price per unit the buyer is willing to pay.

Question 20

What is contribution?

Answer 20

The amount each item contirbutes to paying off other costs.

Question 21

What is the contribution folder?

Answer 21

Selling price - variable costs

Question 22

What is the formula for total contribution?

Answer 22

Contribution per unit x number of units sold

Question 23

Tips for calculating special order conitrbution?

Answer 23

When calculating special order contribution/profit, you assume the fixed costs are already covered by the normal production, meaning you can calculate the extra profits.

Question 24

What are the non financial factors to consider over special orders?

Answer 24

Capacity.
Labour demands.
Could it lead to more regular future orders.
Existing customer relationships.
Product adjustment.