3.8 Investment Appraisal ('23)

Which of the following statements is false?

• The payback period ignores the time value of money

• Discount factors indicate the opportunity cost of money received at a future date

• The Net Cash Flow (NCF) in an investment project is the profit generated during the lifespan of an investment project

• Investments with a positive net present value should be considered on financial grounds

Answer explanation

NCF is used in calculating the ARR and NPV methods of investment appraisal. NCF is the difference between the cash inflow and cash outflow. This is not the same as the total profit earned during the lifespan of an investment project.

The formula for calculating the payback period is:

Initial cost of investment / ____________ ___ _____

Which of the following is an example of an investment decision by a construction company?

• A decision to purchase a new cement mixing machine

• Selling an obsolete timber cutting machine

• A decision to pay dividends to its shareholders

• Taking out a bank overdraft to ensure sufficient working capital

Answer explanation

The decision to purchase a new cement mixing machine is an investment decision for a construction company and the business will need to assess and justify the capital expenditure in terms of whether it will be profitable.

Which of the following attributes is not an advantage of the payback period method of investment appraisal?

• It overlooks the overall profitability of an investment

• It is simple and relatively fast to calculate

• It helps to estimate how fast the initial investment can be recovered

• Managers can easily understand the results

Answer explanation

A disadvantage of the payback period as a method of investment appraisal is that ignores the overall profitability of an investment.

Capital expenditure with the intention of a financial return on this spending at some point in the future. _________

Assuming interest rates are 10% per annum, what is the net present value of receiving $100 in one year’s time?

• $91.09

• $90.00

• $90.91

• $110.00

Answer explanation

Using an interest rate of 10%, the net present value of $100 in a year’s time is $90.91. In other words, $90.91 is the present value of $100 in one year’s time. The net present value of an investment is calculated using a discount factor (the opposite to a compound interest rate figure).

Which investment appraisal method calculates the value of total discounted net cash flows minus the initial cost of an investment project?

• Accounting rate of return

• Payback period

• Net present value

• Discounted cash flows

Answer explanation

The net present value (NPV) of an investment is determined by the difference between the sum of future net cash flows, expressed in today’s value, and the principal amount invested in the project.

Which option describes the meaning of investment appraisal?

• Determining the payback period of an investment project

• Assessing the return of an investment, based on the anticipated profits

• Making sure a business has enough money to survive

• Evaluating the costs and benefits of proposed investment projects

Answer explanation

Investment appraisal is a quantitative method used to evaluate the costs and benefits of any proposed investment project. This could include looking at how long it takes to repay the initial costs of the investment or the rate of financial return on investment, for example.

How is the average rate of return calculated?

• Present value of cash inflows less the accounting net book value of the initial investment

• Profit after tax in the year of break-even divided by the initial investment

• Average annual revenue divided by the initial investment

• Average annual net profit divided by the initial investment

Answer explanation

The average rate of return (ARR) is calculated using the following formula: Average net profit divided by the Initial investment. The average annual profit is calculated by the formula: (Total returns – Initial outlay) divided by Years of the project.

What is the correct formula for calculating the payback period?

• Gross profit ÷ total sales revenue × 100

• Initial investment cost ÷ annual cash flow from investment

• Annual cash flow from investment ÷ initial investment cost

• Annual cash flow from the investment – original cost of investment

Answer explanation

The formula to calculate the payback period is: initial investment cost ÷ annual cash flow from the investment. The payback period estimates the length of time for the cash inflows from an investment to recover the initial project cost.