Unit 7 - Investment Appraisal

Question 1

Investment appraisal

Answer 1

The process of analysing whether investment projects are worthwhile

Question 2

Payback period

Answer 2

The time it takes for a project to repay its initial investment

Question 3

Average rate of return

Answer 3

Looks at the total accounting return for a project to see if it meets the target return

Question 4

Discounted cash flow (NPV)

Answer 4

Net present value calculates the monetary value now of the projects future cash flow

Question 5

Duration time/ payback time equation

Answer 5

(HOW MUCH WE NEED TO GET TO CCF =0/ CASH FLOW NEXT YEAR) X TIME

Question 6

Benefits of using payback period

Answer 6

• simple and easy to calculate and easy to understand results
• focuses on cash flow
• emphasises speed of return (good for markets which change rapidly)
• straight forward to compare competing projects

Question 7

Drawbacks of using payback period

Answer 7

• ignores cash flows after payback has been reached
• takes no account of the “time value of money”
• encourages short term thinking
• ignores qualitative aspects of a decision
• doesn’t actually create a decision for the investment

Question 8

Average (accounting) Rate of Return equation

Answer 8

1) AVERAGE PROFIT PER YEAR = TOTAL PROFIT/ YEARS TAKEN
2) (AVERAGE PROFIT PER YEAR / INITIAL INVESTMENT) X100

Question 9

Benefits of ARR

Answer 9

• easy to understand
• easy to compare to other projects or investments
• considers all the profit for a project, not just pay back

Question 10

Disadvantages of ARR

Answer 10

• only a prediction - incorrect data could lead to poor decisions
• ignores which years are more or less profitable
• ignores the order of profitability in years

Question 11

Net present value

Answer 11

Calculates the current monetary value of a projects future cash flow

Question 12

Discount factor

Answer 12

Measures the level of risk from an investment and is used to calculate how much the future moneys value will differ to its present value

Question 13

Net present value equation

Answer 13

1) CASH FLOW X DISCOUNT RATE
2) ADD UP ALL PRESENT VALUES - INITIAL INVESTMENT

Question 14

What does a high discount factor mean?

Answer 14

Higher risk of failure
E.g. the present value of money becomes less as there is a higher chance that future value won’t happen

Question 15

Effects on the rate of inflows and outflows each year

Answer 15

• changes in exchange rates
• consumer tastes change
• inflation at home and abroad
• possibility of trade problems between countries
• after cost changes (e.g. labour and transport)
• probability of economic and political instability

Question 16

Sensitivity analysis

Answer 16

The use of “what if” scenarios to adjust the figures which could show a different outcome if the situation was altered