unit 7 - investment appraisal

Question 1

what is investment appraisal

Answer 1

process of analysing whether investment projects are worthwhile

• the use of various numerical techniques to make informed management decisions when choosing between capital investments ( buying NCA)
• helps to minimise risks + give managers a better idea of the best choice to make when looking at different alternatives. (ensures investment produces good returns & helps a company achieve its aims and objectives.)

Question 2

payback formula

Answer 2

• period of time it takes for an investment to generate sufficient returns to pay for its initial costs

~ subtract initial cost from inflows/ net cashflow until there is nothing left to pay of the initial investment
~ payback in months = income required / income generated in the year x 12

Question 3

Average rate of return formula

Answer 3

• comparison of the total net return of an investment to its initial cost to see if it produces good return

1. Find total net return (profit) including initial cost
2. Calculate average annual net return: divide profit by number of years
3. Calculate average rate of return
   ARR = avg annual net return/ initial cost of investment x 100

Question 4

net present value formula

Answer 4

• the net return on an investment when all revenue x costs have been converted to their current worth (discounted)

discount factor x net cash flow } add up total for total net present value

Question 5

pros x cons NPV

Answer 5

• pros:
  takes into account the impact of inflation on the value of money over time
  makes the opportunity cost of projects clear
  considers returns x costs over whole life of investment
  considers timing of inflows (smaller discounts for earlier years)

cons:
deciding on discount factors is complex (not accurate)
predicting likely future inflation level can be difficult e.g. 2022 inflation was at 11% in autumn (october)

Question 6

what can investment appraisal techniques be compared to

Answer 6

bench mark

Question 7

other factors in investment decisions

Answer 7

• state of economy + expanding during a recession & interest rates
• quality of data of forecasts
• current financial position + availability of finance
• impact on staff e.g. automation & redundancy
• correlation to environmental + ethical objectives & impact on corporate image
• legislation & actions of rivals
• efficiency

Question 8

sensitivity analysis

Answer 8

‘what if analysis’
- management technique that uses variation in forecast data to investigate a range of possible outcomes.
allows managers to variables in data to see diff possible outcomes + identify likelihood of outcomes happening & risks involved
how sensitive the outcomes of investment appraisal are to changes in variables e.g. sales

Question 9

pros x cons of ARR

Answer 9

pros:
- takes into account the full returns of a project over the life of the investment
- compares returns to initial cost showing return on investment (profitability)
- allows easy comparison btwn projects + shows opportunity cost of investment

cons:
- considers average annual profit so projects may be chosen even tho it only produces a return over a long period of time
- doesn’t attach importance to timing, some projects may not become profitable for many years
- doesn’t take into consideration inflation

Question 10

pros x cons of payback

Answer 10

pros:
-easy to use, little training or expertise needed
- method focuses on cash flow, liquidity + speed of payback
- focus on time = useful in dynamic markets such as tech which becomes obsolete

cons:
~ ignores total return of investment so options that would be more profitable after payback may not be chosen
~ fails to consider impact of inflation on future returns
~ may encourage short-termism = only picking short-term, lower risk options overlooking long term higher return projects