Chapter 73 - Investment Appraisal

Define 'Investment Appraisal'.
An evaluation of the attractiveness of an investment proposal that is medium to long term, using methods such as average rate of return, internal rate of return (IRR), net present value (NPV), or payback period.
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Name a few methods used to evaluate the attractiveness of investment appraisal.
average rate of return, internal rate of return (IRR), net present value (NPV), or payback period.
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How do you calculate pay-back period?
Sum invested / net cash per time period.
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Define 'pay-back period'.
The amount of time it takes to make the money to cover the investment you made. Money in this period is normally at a high risk.
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Define 'criterion level'.
This is a yardstick set by directors to enable managers to judge whether investment ideas are worth pursuing. (e.g. ARR must be 15%+ or must have a PBP of 12 months or less).
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Name a criticism of working out pay-back period.
It only focuses on the short term of how long it will take to cover the investment. It doesn't tell you how much money it will make.
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Define 'short-termism'.
Making decisions on the basis of the immediate future and therefore ignoring the long-term future of the business. This is generally related to the criticism of PBP.
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What are some advantages of the pay-back period method.
Easy to calculate, May be more accurate than other measures because it ignore the longer term forecast, takes into account the timing of cashflows and important for a business with weak cash flow - it may only invest in quick PBP projects.
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What are some disadvantages of the pay-back period method.
Provides no insight into profitability, Ignores what happens after the pay back period, May encourage short-termism and it is not very useful on its own therefore it is used with ARR or NPV.
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What does the 'Average Rate of Return' compare?
This method compares the average annual profit generated by an investment with the amount of money that was invested into it.
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How do you calculate ARR?
1. calculate the total profit over the lifetime of the investment (total net cash flows-investment outlays). 2. divide by the number of years of the investment to get the average annual profit. 3. plug in(average annual return / initial outlay) x 100
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What are some advantages of the average rate of return method.
It uses all of the cashflows over the projects life, it significantly focuses on profitability and easy to compare percentage returns on different investments to come to a final decision.
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What are some disadvantages of the average rate of return method.
Years later are not included therefore will not prove as accurate as PBP, it ignores the timing of cashflows and ignores the opportunity cost of investment.
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Net Present Value
SEE TABLES IN TEXTBOOK
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What are some advantages of the net present value method?
Takes the opportunity cost of money into account, Takes the timing and amount of cashflows into account and can consider different scenarios.
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What are some disadvantages of the net present value method?
Complex to calculate and communicate, The meaning of the result is often misunderstood and it is only comparable between the same projects if the initial investment is the same.
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List non-financial factors in investment appraisal.
Company objectives, Company finances, Confidence in the data and Social responsibilities.
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Define 'present values'.
the discounting of future cashflows to make them comparable with today's cash. This takes into account the opportunity cost of waiting for the cash to arrive.
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Card 2

Front

Name a few methods used to evaluate the attractiveness of investment appraisal.

Back

average rate of return, internal rate of return (IRR), net present value (NPV), or payback period.

Card 3

Front

How do you calculate pay-back period?

Back

Preview of the front of card 3

Card 4

Front

Define 'pay-back period'.

Back

Preview of the front of card 4

Card 5

Front

Define 'criterion level'.

Back

Preview of the front of card 5
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