Paper 2- Theme 3.3 Decision Making Techniques (3.3.2 & 3.3.4)

Question 1

Define investment appraisal

Answer 1

the process of using quantitative data to asses the financial value of possible future investments

Question 2

define payback

Answer 2

the amount of time it takes for an investment’s earnings to recoup the original cost of it.

Question 3

payback month is calculated by

Answer 3

income needed

next year income ÷ 12 months

Question 4

positives and negatives of payback

Answer 4

PROS

• quick and easy
• sole focus on breaking even
• ignores long term forecasts which may be less accurate

CONS

• doesn’t consider profitability
• ignores cash flow after payback period
• may encourage short-termism
• assumes receivables are steady throughout year (no idea of the timing of these)

Question 5

define average rate of return

Answer 5

method used to calculate the net return per year as a % of the initial investment cost

Question 6

formula for ARR

Answer 6

average annual income
————————————- x 100
investment initial cost

Question 7

strengths and weaknesses of ARR

Answer 7

PROS

• can compare with changing interest rates (see if saving is more beneficial)
• incorporates profitability and cash flow after full recoup of investment
• easily compare with other investments to reduce opportunity cost

CONS

• long term forecast more vulnerable to external changes
• assume firms only pursuing profit objectives
• ignores the timing of cashflows
• ignores time value of money (inflation)

Question 8

factors affecting investment decisions (less common)

Answer 8

• corporate objectives (short term or long term)
• accuracy of data the forecast is based on and those interpreting forecasts
• social responsibilities (CSR, recycling or social schemes may have low ARR but still be done to gain publicity)

• wealth in company finance (e.g. gearing, liquidity)
- whether they can afford risk and uncertainty

Question 9

define net present value

Answer 9

calculates the value of potential earnings in the future, in the present

Question 10

define discounted cash flow

Answer 10

process of adjusting value of earnings in the future to its value in the present

Question 11

formula for net present value

Answer 11

income x discount factor

Question 12

what does the discount factor represent

Answer 12

what the interest rate is expected to be

Question 13

positives and weaknesses of net present value

Answer 13

•PROS

• can see if any project is worth or if the opportunity cost of saving money in bank is more beneficial
• considers timing and amount of cashflows
• can cover different scenarios (interest rates at different levels)

•CONS

• complex to calculate & can’t compare projects with different initial cost
• assume discount factor will stay the same (unlikely interest rates will stay same)
• final value depends heavily on forecasted discount factor

Question 14

define critical path analysis

Answer 14

process of planning the sequence of activities, to find the fastest way to complete a project

Question 15

purpose of critical path analysis

Answer 15

allows a business to
• see how long the whole project should take
• estimate the minimum time that each activity should take
• identify any tasks that may cause a delay to the project finishing

Question 16

strengths of critical path analysis

Answer 16

• allows for efficient planning of resources, with contingencies
• minimise risk of missing deadlines (especially time sensitive projects) and also overspending
• provide overview of long or complex projects
—> can be useful when combining with IA methods to see if project is worthwhile

Question 17

weaknesses of critical path analysis

Answer 17

• diagram may be overcomplicated, may lead to lack of clarity between workers
• relies on estimates (budgeting and cash flow estimates)
• project stills needs successful management and communication to be successful
• may be unnecessary if firm has experience completing project before
• may focus too much on deadlines and not enough on quality

Question 18

calculate & define float time

Answer 18

LFT - activity duration - EST

float time- the duration an activity can be extended by, without delaying the whole project

Question 19

what is the critical path

Answer 19

the activities that can’t be delayed without delaying the project’s finish time