Unit 5. Chapter 33. Investment Appraisal

Question 1

investment appraisal

Answer 1

evaluating the profitability or desirability of an investment project

Question 2

5 quantitative methods of investment appraisal

Answer 2

1. payback period
2. average rate of return
3. discounted payback
4. net present value
5. internal rate of return

Question 3

annual forecasted net cash flow

Answer 3

is forecast cash inflows - forecast cash outflows

Question 4

External factors affecting the revenue forecasts

Answer 4

• an economic recession could reduce both business and tourist traffic through the airport
• increases in oil prices -> air travel more expensive, reducing revenue totals
• construction of a new high-speed rail link with the country -> encourage some travellers to switch to this form of transport.

Question 5

1. Payback period

Answer 5

length of time it takes for the net cash inflows to pay back the original capital cost of the investment

Question 6

Why is the payback of a project important?

Answer 6

• Managers can compare with alt. projects to put them in rank order and ‘cut-off’ time period that the business may have laid down.
  + Borrowed the finance for the investment and a long payback period -> increase interest payments
  + Finance obtained internally, the capital has an opportunity cost of other purposes -> speedier payback = quicker the capital is made available for other projects.
  + Longer into the future before a project pays back the capital invested in it, the more uncertain the whole investment becomes.
  + Reduce risk to a minimum -> quick payback reduces uncertainties.
  + Inflation, the quickly money is returned to an investing company, the higher will be its real value.

Question 7

Information required for using quantitative techniques

Answer 7

• the initial capital cost of the investment (equipment and machinery, installation)
• the estimated life expectancy
• the residual value of the investment
• the forecasted net returns or net cash flows from the project.

Question 8

Advantages of payback method

Answer 8

• Quick and easy to calculate
• The results are easily understood by managers
• The empasis on speed of return of cash flows gives the benefit of concentrating on the more accurate short-term forecasts of the project’s profitability.
• Result can be used to eliminate or ‘screen out’ projects that give returns too gar into the future.
• Useful for business where liquidity is of greater significance than overal profitability.

Question 9

Disadvantages of payback method

Answer 9

• Doesn’t measure the overall profitability of a project - ignores all the cash flows after the payback period. May be possible for an investment to give a really rapid return of capital, but then to offer no other cash inflows.
• This concentration on the short term may lead businesses to reject very profitable investments just because the take some time to repay the capital.
• Doesn’t consider the timing of the cash flows during the payback period
• Takes no account of the value of money over time.

Question 10

2. Average rate of return (ARR)

Answer 10

measures the annual profitability of an investment as a percentage of the initial investment
ARR (%) = annual profit (net cash flow)/ initial capital cost x 100

Question 11

Advantages of ARR

Answer 11

• uses all of the cashflows
• focuses on profitability, which is the central objective of many business decisions.
• the result is easily understood and easy to compare with other projects that may be competing for the limited investment funds available.
• result can be quickly assessed against the predetermined criterion rate of the business.

Question 12

Disadvantages of ARR

Answer 12

• ignores the timing of the cash flows. This could result in 2 projects having similar ARR results, but one could pay back much more quickly than the other.
• As all cash inflows are included, the later cash flows, which are less likely to be accurate, are incorporated into the calculation.
  the time value of money is ignored as the cash flows have not been discounted.

Question 13

3. Discounted payback

Answer 13

uses discounted cash flows to calculate the payback period of the capital cost. It does take the time value of money into account.

Question 14

4. Net present value (NPV)

Answer 14

today’s value of the estimated cash flows resulting from an investment.
net cash flow x discounting factor

Question 15

3 stages of NPV

Answer 15

1. multiply discount factors by the net cash flows. Cash flow in year 0 are never discounted, as they are today’s values already
2. add the discounted cash flows
3. subtract the capital cost to give the NPV.

Question 16

Advantages of NPV

Answer 16

• considers both the timing of cash flows and the size of them in arriving at an appraisal.
• the rate of discount can be varied to allow for different economic circumstances.
• considers the time value of money and takes the opportunity cost of money into account.

Question 17

Disadvantages of NPV

Answer 17

• it is reasonably complex to calculate and to explain - especially to non-numerate managers.
• the final result depends greatly on the rate of discount used, and expectations about interes rates may be inaccurate.
• NPV can be compared with other projects, but only if the initial capital cost is the same. This is because the method does not provide a percentage rate of return on the investment.

Question 18

5. Internal rate of return (IRR)

Answer 18

the rate of discount that yields a net present value of zero - the higher the IRR, the more profitable the investment project is.

Question 19

IRR can be compared with

Answer 19

• other projects
• the expected rate of interest over the life of the investment
• the business’s criterion or cut-off rate

Question 20

Advantages of IRR

Answer 20

• giving a percentage rate of return, different projects costing different amounts can be compared.
• IRR is easily compared with the rate of interest or the criterion rate of the business.
• avoids the need to choose an actual rate of discount

Question 21

Disadvantages of IRR

Answer 21

• the calculation is tedious without calculator
• by giving an exact result, it can mislead business users into believing that investment appraisal is a precise process without risk and uncertainties.

Question 22

Criterion rates or levels

Answer 22

the minimum levels (maximum for payback period) set by management for investment appraisal results for a project to be accepted.

Question 23

Qualitative factors

Answer 23

• The impact on the environment and the local community - growing concern about environmental issues -> businesses carefully plan for developments in sensitive areas (bad publicity, long-run impact on image and sales.
• Certain projects may not receive planning permission
• > prevent continuation of the scheme, members of that community will often have a direct role through a public enquiry or may set up a pressure group to make their views known and try to achieve a particular outcome.
• Aims and objectives of the business must be a key consideration.
• Different managers are prepared to accept different degrees of risk.

Question 24

Investment appraisal - Evaluation

Answer 24

• Mislead into assuming that the results must be certain and definite.
• Uncertainties over future cash flows, operating costs, movements in interest rates and other variables -> important guides.
• Conflicting nature of the results that are often obtained from investment-appraisal calculations.
  + fast payback or higher ARR or NRV
  + depend on the manager’s attitude to risk and the balance to be achieved between risk.
• Significance of objectives. demand for ethical decision making that considers wider issues than just short-term shareholder returns.
• Necessary but not sufficient guidelines for business-investment decisions.