7.5 Investment Appraisal (AQA A Level Business): Flashcards
Exam code: 7132
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Define investment appraisal.
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Cards in this collection (33)
Define investment appraisal.
Investment appraisal compares the expected future cash flows of an investment with its initial outlay.
Name the three investment appraisal methods.
The payback period, the average rate of return (ARR) and net present value (NPV).
Define the payback period.
The payback period is the amount of time an investment is expected to take to pay for itself.
State the formula for payback (constant cash flows).
Payback period = initial outlay ÷ net cash flow per period.
Initial outlay £200,000, net cash flow £30,000/year. Calculate the payback period.
£200,000 ÷ £30,000 = 6.67 years = 6 years and 8 months.
Give one benefit and one drawback of the payback method.
Benefit: simple and good for cash flow; drawback: it ignores profitability and the timing/value of later cash flows.
Define the average rate of return (ARR).
ARR compares the average annual profit from an investment with the initial outlay, expressed as a %.
State the formula for ARR.
ARR = (average annual return ÷ initial outlay) × 100.
Total profit £48,000 over 6 years, initial outlay £40,000. Calculate ARR.
Average annual profit = £48,000 ÷ 6 = £8,000; (8,000 ÷ 40,000) × 100 = 20%.
Give one drawback of ARR.
It ignores the timing of cash flows (and the opportunity cost of the money).
Define net present value (NPV).
NPV is the present value of future cash inflows minus outflows, taking account of interest rates and time.
Why does NPV discount future cash flows?
Money received in the future is worth less than today — due to inflation and the opportunity cost of not having it now.
How do you interpret a positive versus negative NPV?
Positive = the investment is likely worthwhile; negative = it is unlikely to be worthwhile.
An NPV calculation gives −£12,550. Is the investment worthwhile?
No — a negative NPV suggests the investment is not financially worthwhile.
Give one benefit and one drawback of NPV.
Benefit: it considers opportunity cost and time; drawback: it is complex and depends on the discount rate and accurate forecasts.
Give one general limitation of all investment appraisal methods.
They rely on forecast future cash flows that may be inaccurate, and they ignore non-financial factors.
A positive net present value suggests an investment is likely to be .
A positive net present value suggests an investment is likely to be worthwhile.
True or False?
The payback method measures how profitable an investment is.
False.
It only measures how long an investment takes to pay for itself, not its profitability.
True or False?
NPV takes into account the effects of interest rates and time.
True.
NPV discounts future cash flows to today's terms, reflecting interest rates and the time value of money.
Name two financial investment criteria.
Expected profits vs costs and availability/cost of finance (also cash flow, tax breaks/grants and market demand).
Why does the cost of finance matter for investment?
Low interest rates make borrowing cheaper, providing an incentive to fund big purchases.
Why does cash flow matter even if borrowing is possible?
A project won't start if it leaves the business unable to pay its day-to-day bills.
How can government tax breaks or grants affect investment?
They cut the cost of an investment, making it more attractive.
Name two non-financial factors affecting investment.
Technological change and the regulatory/legal environment (also social trends, sustainability goals and skilled labour).
How can new laws influence investment?
Firms may have to upgrade systems or processes to stay compliant (e.g. BA spent £50m+ on IT security after GDPR).
Define risk (in investment).
Risk is where a business can estimate the possible outcomes and their probabilities.
Define uncertainty (in investment).
Uncertainty is where a business cannot estimate the possible outcomes or their probabilities.
Give an example of a risk affecting investment.
Price fluctuations (e.g. rising raw material costs) or demand swings.
How might a business respond to uncertainty about future regulations?
Delay big projects until rules are clear, or split them into stages to adjust later.
How might a business respond to uncertainty about technology?
Wait to see which technology wins, choose upgradeable machines, or lease rather than buy.
Firms can reduce exposure to uncertainty by phasing spending — doing part of a project now and adding more .
Firms can reduce exposure to uncertainty by phasing spending — doing part of a project now and adding more later.
True or False?
Risk and uncertainty mean the same thing in investment decisions.
False.
Risk = outcomes and probabilities can be estimated; uncertainty = they cannot.
True or False?
Businesses only ever consider financial factors when making investment decisions.
False.
They also weigh non-financial factors such as technology, regulation, sustainability and skilled labour.
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