3.5 Capital Investment Appraisal

• Capital Investment Appraisal involves using techniques such as Net Present Value ($NPV =$$\sum_{t = 0}^{n} \frac{CF_{t}}{(1 + r)^{t}}$) and Internal Rate of Return ($IRR$) to make informed decisions
• Capital Investment Appraisal is essential for ensuring efficient resource allocation and maximizing return on investment.
• Arrange the reasons for Capital Investment Appraisal in a logical order based on their benefits for a business.

  1️⃣ Informed Decision Making

  2️⃣ Efficient Resource Allocation

  3️⃣ Maximizing Return on Investment

  4️⃣ Long-Term Growth

  5️⃣ Risk Management
• Match the Capital Investment Appraisal method with its definition and formula.

  Net Present Value (NPV) ↔️ Measures the present value of future cash flows minus the initial investment.

  Internal Rate of Return (IRR) ↔️ Calculates the discount rate at which the NPV equals zero.

  Payback Period ↔️ Determines how long it takes for an investment to recover its initial cost.

  Accounting Rate of Return (ARR) ↔️ Calculates the average annual profit as a percentage of the initial investment.
• The formula for Net Present Value (NPV) is NPV = \sum_{t = 0}^{n} \frac{CF_{t}}{(1 + r)^{t}}</latex>
• The Accounting Rate of Return (ARR) is calculated using the formula: $ARR =$$\frac{\text{Average Annual Profit}}{\text{Initial Investment}} \times 100$. This formula provides a quick overview of profitability
• What is the ARR for a project costing £50,000 with average annual profits of £8,000?

  16%
• The Accounting Rate of Return (ARR) considers the time value of money.

  False
• When used within the Capital Investment Appraisal process, ARR helps companies prioritize projects based on their profitability potential
• The formula for calculating the Accounting Rate of Return (ARR) is Average Annual Profit divided by the initial investment.
• What is a key advantage of using the Accounting Rate of Return (ARR)?

  Simplicity
• The Accounting Rate of Return (ARR) considers the time value of money.

  False
• The formula for calculating the Payback Period is initial investment divided by annual cash inflow.
• What does the Payback Period method ignore in its calculations?

  Time value of money
• The Payback Period should be used alone in capital investment appraisal.

  False
• What does Net Present Value (NPV) measure?

  Present value of cash flows
• Match the key components of Capital Investment Appraisal with their definitions:

  Costs ↔️ Expenses incurred for the investment

  Revenues ↔️ Income generated by the investment

  Risks ↔️ Uncertainties that could impact success

  NPV ↔️ Measures present value of cash flows
• Capital Investment Appraisal ensures investment projects are based on sound financial analysis.
• Capital Investment Appraisal aims to identify projects with the lowest potential return.

  False
• What is the primary disadvantage of using the Payback Period method?

  Ignores time value of money
• The Internal Rate of Return (IRR) calculates the discount rate at which NPV equals zero.
• The Accounting Rate of Return (ARR) uses cash flows instead of accounting profit.

  False
• Order the advantages and disadvantages of using the Accounting Rate of Return (ARR):

  1️⃣ Simple and easy to understand

  2️⃣ Provides a quick overview of profitability

  3️⃣ Does not account for the time value of money

  4️⃣ Uses accounting profit rather than cash flows
• What is the ARR for a project with a £50,000 investment and £8,000 average annual profit?

  16%
• The Payback Period measures the time it takes for an investment to recover its initial cost.
• The Payback Period considers cash flows beyond the payback period.

  False
• The payback period for an investment of £100,000 with annual inflows of £25,000 is 4 years.
• What is the payback period used in capital investment appraisal?

  Prioritizes faster returns
• The formula for calculating the payback period is \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}.
• The payback period accounts for the time value of money.

  False
• The Net Present Value (NPV) measures the present value of expected future cash flows minus the initial investment.
• Match the advantage of NPV with its description:

  Accounts for time value of money ↔️ Recognizes the diminishing value of money over time

  Comprehensive assessment of profitability ↔️ Considers all cash flows and their timing
• What does CF_{t} represent in the NPV formula?

  Cash flow at time t
• For a project with an initial investment of £50,000, annual inflows of £15,000, a discount rate of8%, the NPV is £9,944.30.
• If the NPV of a project is positive, the project is considered profitable.
• What is the Internal Rate of Return (IRR) used for in capital investment appraisal?

  Determines project profitability
• The IRR is the discount rate that makes the net present value of all cash flows equal to zero.
• What is the approximate IRR for a project with an initial investment of £50,000 and annual inflows of £15,000 for 5 years?

  15.24%
• If the company’s cost of capital is above the IRR, the project is considered worthwhile.

  False
• The Accounting Rate of Return (ARR) measures average annual profit as a percentage of the initial investment.