Lecture 1 - Investment Appraisal

Question 1

What is the point of investment appraisal?

Answer 1

• To decide whether an investment will be worthwhile or not.
• Or to choose between 2 or more investment opportunities.

Question 2

3 important questions which should be asked when taking out investment appraisal:

Answer 2

• Return
• Risk
• Timing

Question 3

The 4 traditional investment appraisal techniques are…

Answer 3

• Payback period
• Accounting rate of return
• Net present value
• Internal rate of return

Question 4

An overview of investment appraisal:

Answer 4

• Depreciation is not a cashflow it is an accounting adjustment.
• Cash flow based techniques measure cashflows and not accounting profit.
• Cash flows are assumed to either take place immediately or at the end of the accounting period
• For cashflow techniques you must use inflows and outflows and not accounting income and expenditure.

Question 5

Payback period (PP):

Answer 5

• Shows the time it takes to pay back the initial investment.
• Work this out by finding the net cashflows from each year. Then income required divided by income generated X 12

Question 6

Evaluation of the Payback period:

Answer 6

• Ignores cashflows once the payback date has been reached.
• Simple payback ignores the time value of money.
• It is most relevant when companies have liquidity or financing constraints.

Question 7

Accounting Rate of Return (ARR):

Answer 7

• Measures the profitability of an investment based on accounting profit and not cashflow.
• Looks at annual average profit
• We adjust cash inflows to reflect how businesses report profit.

Question 8

ARR summary:

Answer 8

• Focuses on profitability whereas other investment appraisal methods focus on cashflow timings.
• Businesses compare ARR to a target return to see whether the investment is worthwhile.
• Higher ARR = More profitable of investment (if risk is similar)

Question 9

Discounting cashflows NPV and IRR:

Answer 9

• Both methods adjust for the time value of money by reducing future cashflows back to their current value.
• Known as DCF techniques.

Question 10

What is the Time value of Money concept:

Answer 10

• Concept that money is worth more if it is received now than if it is received in the future because of:
• Investment/opportunity costs.
• Effect of inflation
• Risk/uncertainty of the cashflow.

Question 11

NPV summary:

Answer 11

• The discount rate applied represents the minimum acceptable return for the investor.
• Allows for timing of cashflows

Question 12

IRR summary:

Answer 12

• IRR is the discount rate that makes NPV = 0, it tells us the exact return an investment generates.
• Gives a % return figure
• Less flexible and meaningful than NPV
• Does not tell us the scale of investment.

Question 13

Calculating IRR:

Answer 13

• Calculate IRR by the interpolation using 2 NPV values at different discount rates.