Meaning of investment appraisal:

Question 1

What does investment appraisal do ?

Answer 1

Informs management decision making when choosing between capital investments

Question 2

3 methods of investment appraisal:

Answer 2

• Payback
• Average rate of return
• Net present value

Question 3

Payback is…

Answer 3

Period of time taken for an investment to generate sufficient returns to pay back the initial costs/investments

Question 4

Payback formula =

(need to work out the net cash inflows for each year if only inflows and outflows are given)

Answer 4

Month of payback =

Income generated in the next year

X 12

Question 5

Value of payback:

Answer 5

Positives:
- Good to use for firms which have been experiencing liquidity problems in the past, possibly smaller business’s as they need profits to survive.
- Smaller payback less opportunity costs

Negatives:
- Doesn’t take into account doesn’t take into account the investments net return after the payback period.

Question 6

What does ARR do that Payback does not do:

Answer 6

Takes into account the problems of payback and considers the total return of an investment over it’s whole life span.

Question 7

ARR equation:

Answer 7

Capital cost of investment

X100

Question 8

3 steps to calculating ARR:

Answer 8

1) Calculate the profit of the project:
Profit=Total inflows/revenue - Total outflows (including the initial cost of the investment)

2) Calculate the average annual profit: Divide the profit for the investment by the expected life (years) of the capital investment

3) Put numbers into the equation but dont forget to X100

Question 9

Value of ARR:

Answer 9

Positives:
- More useful than payback as it accounts for the level of profits earned by an investment

Negatives:
ARR doesn’t account for time, so therefore doesn’t take into the account that money will diminish in value over time due to inflation

Good ARR rate will depend on last year and other investments

Question 10

Net present value formula

Answer 10

cash inflows X discount value

Then add them up and take away from the initial investment

Question 11

Value of NPV:

Answer 11

Postives;
Factors time factor into our returns
Takes into account for all the years of a projects life

Negatives:
Discount factors may not be accurate as they are influenced by inflation and external environment