Lecture 3 - Investment Appraisal Techniques

Question 1

What is the first step in investment appraisal?

Answer 1

Quantify the benefits and costs of a project in the form of cash flows.

Question 2

What is the second step in investment appraisal?

Answer 2

Take the cash flows and apply an appraisal test to decide if the benefits will cover the costs.

Question 3

What are the components involved in the ABC plc example for opening a new store?

Answer 3

Buy land for the store (£10m), build the store (£4m), equip the store (£2m), staff the store (£3m per year), restock the store (£3m per year), sales income (£11m per year), and maintenance (£1m per year).

Question 4

What is Net Present Value (NPV) approach?

Answer 4

A method to appraise any project by setting up a cash flow table, converting cash flows to present values using discounting, and summing these to get NPV.

Question 5

When should a project be accepted based on NPV?

Answer 5

A project should be accepted if NPV is greater than 0.

Question 6

What does an NPV of 0.7784 indicate?

Answer 6

It indicates that the project will bring a net profit of £778400 considering all costs, and the rate of return on the project is greater than the market interest rate of 5%.

Question 7

What is the significance of the discount factor in NPV calculation?

Answer 7

It converts future cash flows to their present values, making them comparable across different time periods.

Question 8

What is the NPV rule?

Answer 8

Accept a project if it has a positive NPV. If multiple projects have positive NPV, select the one with the highest NPV.

Question 9

What is the profitability index (PI)?

Answer 9

A ratio of the sum of present values (PVs) to the initial investment, used to rank projects.

Question 10

What does a profitability index (PI) greater than 1 indicate?

Answer 10

It indicates that the sum of present values is greater than the initial investment, making the project desirable.

Question 11

List some strengths of the NPV approach.

Answer 11

Maximizes shareholder wealth, takes into account all future cash flows and their timing, computationally easy, and provides a clear decision signal (NPV>0).

Question 12

List some weaknesses of the NPV approach.

Answer 12

Requires estimating future cash flows and using the correct discount rate, which can be challenging and biased.

Question 13

What should be done if cash flows occur at different times during the project?

Answer 13

Convert all cash flows to the present using discounting to make them comparable.

Question 14

How is the present value (PV) of a cash flow calculated?

Answer 14

The present value is calculated using the formula PV=CashFlow×DiscountFactorPV = \text{Cash Flow} \times \text{Discount Factor}PV=CashFlow×DiscountFactor.

Question 15

What is the net present value (NPV) of a project?

Answer 15

NPV is the sum of the present values of all cash flows associated with the project.

Question 16

What does it mean if NPV is greater than 0?

Answer 16

It means the project is expected to generate more wealth than the cost, making it a desirable investment.

Question 17

What is the profitability index (PI)?

Answer 17

PI is the ratio of the sum of present values (PVs) of cash flows to the initial investment.

Question 18

What does a profitability index (PI) greater than 1 indicate?

Answer 18

It indicates that the sum of present values of the cash flows is greater than the initial investment, making the project desirable.

Question 19

What should be done if multiple projects have positive NPVs but only one can be chosen?

Answer 19

Choose the project with the highest NPV.

Question 20

List some strengths of the NPV approach.

Answer 20

Maximizes shareholder wealth, accounts for all future cash flows and their timing, computationally easy, provides a clear decision signal (NPV>0).

Question 21

List some weaknesses of the NPV approach.

Answer 21

Requires estimating future cash flows, uses a discount rate that needs to be accurate, and may be subject to biased guesses.

Question 22

What is the interpretation of a profitability index (PI) in simple investment cases?

Answer 22

PI measures the present value of cash flow per unit of investment. A higher PI indicates a more desirable investment.

Question 23

When should a project not be invested in based on PI?

Answer 23

When the profitability index is less than 1, indicating the sum of present values is less than the initial investment.

Question 24

What is the NPV rule?

Answer 24

Accept a project if it has a positive NPV. If multiple projects have positive NPVs, choose the one with the highest NPV.

Question 25

How should projects be ranked if several have NPV>0 and enough investment funding is available?

Answer 25

Choose the projects in order of decreasing NPV.

Question 26

What does an NPV of 0 indicate?

Answer 26

You are getting precisely the required rate of return.

Question 27

What is the simplified investment model used in profitability index calculations?

Answer 27

A model where there is a single initial investment and annual cash inflows over the project life. Future cash flows are discounted at the required rate of return.