Theme 3 - 3.3.2 - Investement appraisal

Question 1

Investment appraisal defined ?

Answer 1

Investment appraisal attempts to determine the value of capital expenditure projects. It enables the business and its investors to
compare projects so that the business can expand and meet their objectives – usually profit maximisation and efficiency.

So basically the project has to be appraised to see if it will be profitable to go forward with or not

Question 2

Whats the planning process for investment appraisal ?

Answer 2

Investment appraisal is the planning process used to determine whether the long term investments will give the best return

Projects such as:
- new machinery
- New premises
- research and development projects

Question 3

What is Investment appraisal - decision making ?

Answer 3

A business will have lots of different ideas for projects like - new machinery or new premises or money into research - and proposals of ways to grow the business - the business will only have a finite amount of money and so perhaps only one project would get the funding it needs to go ahead - investment appraisal is used to work out which project should get the funds

Question 4

What is simple payback ?

Answer 4

A business needs to decide which project or proposal to invest in

it cannot afford all of them therefore the business has a lot of methods to work out which one should be picked and have money spent on it

The table in simple payback starts with the years and the different proposals - starting with year 0 as this shows how much money is invested in the project to begin with - to get it started and then the years after show how much money the project has made therefore if it goes to year 5 for example then you can see how much the project wil make at the end of the 5 years and see if it makes a profit

Question 5

Payback calculation ?

Answer 5

You have a payback period - which is the period it takes ( number of years and months it takes to pay back the money invested ) so if entering year 3 you have 10k left to payback but in year 3 the number says 30k has been generated then you can divide 30 by 12 to see how much money is paid each month

Question 6

So in the payback method of investment appraisal how do you pick which project to pick?

Answer 6

You pick the one that takes the smallest amount of time to payback the original amount invested - in years and months

Question 7

What is ARR explained ?

Answer 7

Payback is a very simplistic tool and only looks at when the project will pay back and does not take into account rate of return

So a business can also use the ARR system which looks at the average rate of return of the projects

Question 8

Whats the ARR calculation ?

Answer 8

First you add up all of the cash inflows form the years so for example for 5 years and then you minus the original cost of the project and then divide this amount of years the project has been running for and then divide this figure by the cost of the project to get a percentage rate of return

But then you have to calculate the other proposals so that you can compare which proposal would be the best - then you can see which rate if return is satisfactory

Question 9

What is NPV ?

Answer 9

Once a business has looked at the payback period for a set of projects and then looked at the ARR they may need to look at the NPV

This is the net present value and it takes into account that money in the future is not worth what it is today - so it adds in a discount table to make it more realistic - as inflation is always going up technically the money could be worth less later so the discount table takes into account that money may be worth less - inflation

So you multiply each cash inflow by the discount this gives the present value column

NPV is all the NPV values added together then minus the initial cost

You get the discount table already done

Question 10

What isn payback period ?

Answer 10

Payback period – is the time period for the original financial investment cost of a project to
be fully recovered

This is the length of time that the money invested is at risk

Question 11

What are the limitations of investment appraisal ?

Answer 11

Payback limitations - very simple, only looks at speed of payback and does not look at profitability

ARR limitations - Does not take into account the effects of time on the value of money - for eg inflation

NPV limitations - very complex, not used by small business, also results dependent on rate of discount used, the higher the rate the more likely it is that the project will be rejected as unprofitable