Unit 3.8 : Investment Appraisal

Question 1

Investment

Answer 1

1. Investment refers to the purchase of an asset with the potential to yield future financial benefits such as the purchasing of a building
2. With most investments, resources are risked in a venture that might or might not bring about future advantages

Question 2

Investment appraisal

Answer 2

1. Investment appraisal refers to the quantitative techniques used to calculate the financial costs and benefits of an investment decision
2. e.g. the different methods used to assess the risks involved in investment decision-making
3. The 3 main methods of investment appraisal are payback period, average rate or return, and net present value

Question 3

Payback period

Answer 3

1. Payback period refers to the amount of time needed for an investment project to earn enough profit to repay the initial cost of the investment
2. Most investment projects would only be considered if they have a relatively short PBP

Question 4

Payback period formula

Answer 4

PBP = Initial investment cost/Contribution per month

Question 5

Advantages of using payback period

Answer 5

1. The PBP is the simplest and quickest method of investment appraisal, hence is it the most commonly used
2. It can be useful for firms with cash flow problems as they can identify how long it would take for the cash to be recouped
3. Allows for a firm to see whether it will break-even on the purchase of an asset before it needs to be replaced: important in today’s fast-paced business environment
4. The payback period can be used to compare different investment projects with different costs by calculating the quickest PBP of each option
5. Helps to assess projects which will yield a quick return for shareholders

Question 6

Disadvantages of using payback period

Answer 6

1. Contribution per month is unlikely to be constant as demand is prone to seasonal fluctuations so PBP might be longer
2. PBP focuses on time as the key criterion for investment, rather than on profits which is the main aim of private sector businesses
3. It can encourage a short-termism approach to investment where managers only focus on short-term benefits and not the potential gains in the long term
4. PBP might not be highly suitable for some firms such as property developers were they are unlikely to recoup their investments for many years
5. Calculations are prone to errors as it is difficult to accurately predict cash flows

Question 7

Average rate of return

Answer 7

1. ARR calculates the average profit on an investment project as a percentage of the amount invested
2. ARR enables managers to compare the rate of return on other investment projects
3. As a basic benchmark, ARR can be compared with the interest rate to assess the rewards for the risk involved in an investment - rate of return should be higher than the interest rate if you were to put money in the bank

Question 8

ARR formula

Answer 8

ARR = (total profit during project’s lifespan / number of years of project) / initial amount invested

Question 9

Pros of ARR

Answer 9

1. It enables easy comparisons of the estimated returns of different investment projects
2. e.g. If two projects are predicted to yield the same ARR, then the relatively cheaper project might be more desirable given that it carries less financial risk

Question 10

Cons of ARR

Answer 10

1. Ignores the timing of cash inflows and hence is prone to forecasting errors when considering seasonal factors
2. The project’s useful life span (which is usually a guess or estimate) is needed before any meaningful calculations can be made.
3. As with all time-based forecasts, errors are more likely the longer the time period under consideration

Question 11

Net present value

Answer 11

1. Money received today can be invested or simply saved in a bank to earn compound interest, whereas money received in the future will have lost some of its value
2. e.g. if you have $100 and decide to place it into a bank account paying 5% interest, at the end of the year you will have $105 so in a year’s time $105 is worth the same as $100
3. Cash today is worth more than cash tomorrow
4. Inflation also reduces the value of money in the future so you have to calculate the present value of money in order to distinguish the yields of investment over different time periods
5. NPV calculates the total discounted net cash flows minus the initial cost of an investment. If the NPV is positive, then the project is viable on financial grounds

Question 12

Discounting

Answer 12

1. Discounting is the reverse of calculating compound interest
2. A discount factor is used to convert the future net cash flow to its present value today
3. Given that receiving money today is worth more than it is in the future, the discount factor can represent inflation or interest rates

Question 13

Qualitative investment appraisal

Answer 13

qualitative investment appraisal refers to judging whether an investment project is worthwhile through non-numerical means such as “is the investment consistent with the corporate culture

Question 14

Quantitative investment appraisal

Answer 14

quantitative investment appraisal refers to judging whether an investment project is worthwhile based on numerical and financial interpretations such as the PBP ARR and NPV