Theme 3 Topic 7 - Investment Appraisal

Question 1

Define Investment Appraisal

Answer 1

A scientific approach to investment decision making which investigates the expected financial consequence of an investment in order to assist the business in its choices

Question 2

What are the three quantitative calculations?

Answer 2

Payback, ARR, NPV

Question 3

What financial information does a business need to do the calculations?

Answer 3

Initial cost of investment, Estimated net return (revenue-cost) per year, Estimated lifetime of the investment

Question 4

Define Payback

Answer 4

The length of time it takes for an investment to pay for itself

Question 5

Does a business want a long or short payback period?

Answer 5

A business will want a payback period as short as possible

Question 6

Payback =

Answer 6

(Cumulative Return of Payback Year/Net Return Following Year) x 52 OR 12

Question 7

What are three advantages of payback?

Answer 7

Focuses on early cash flow so good for businesses with liquidity worries, Useful when investment cost needs recovering quickly, Simple to use

Question 8

What are three disadvantages of payback?

Answer 8

Cash earned after payback period is ignored, Time value of money is ignored, Focusing on payback results in short-termism

Question 9

Define Average Rate of Return (ARR)

Answer 9

The average return of the investment, expressed as a percentage of the initial cost of the investment

Question 10

Does a business want a high or low ARR?

Answer 10

A business will want as high a rate of ARR as possible (it should be higher than bank interest rates)

Question 11

Average Rate of Return =

Answer 11

(Average Annual Profit/Initial Cost of Investment) x 100

Question 12

What are three advantages of ARR?

Answer 12

Clearly shows profitability of investment, Includes returns from all years, Can be compared with bank interest rates in a savings account

Question 13

What are two disadvantages of ARR?

Answer 13

Time value of money is ignored, Harder and more time consuming to calculate than payback

Question 14

Define Net Present Value (NPV)

Answer 14

The net return of an investment when all future cash flows have been converted to their current worth

Question 15

What are the three steps to calculate NPV?

Answer 15

1) Multiply each net return by the given discount factor
2) Add all the answers to get the total discount factor
3) Minus the initial investment cost to give the NPV

Question 16

A positive NPV is…

Answer 16

Worthwhile

Question 17

A negative NPV is…

Answer 17

Not worthwhile

Question 18

What are two advantages of NPV?

Answer 18

Considers the time value of money and converts financial returns into present value, Recognises it is more important to have money now than in the future

Question 19

What are two disadvantages of NPV?

Answer 19

More complex to calculate and understand, Interest rates chosen may be out of date if interest rates change

Question 20

What are six examples of qualitative factors to consider when making an investment?

Answer 20

Economy, Aim of organisation, Reliability of the data, Risk, Image, Personnel