Key terms
Factors that cannot be measured in numerical or financial terms that are considered by managers before taking decisions.
Qualitative Factors
A project costs $10,000 and generates $2,000 per year.
How long is the payback period?
5 years
($10,000 ÷ $2,000)
An investment has a an annual rate of return of -4%. What happened to its value by the end of the year
It decreased/ lost value
What is time value of money
Why money today is worth more than money in the future
Which factor related to society and surroundings can influence whether an investment goes ahead?
Its impact on the environment and the local community.
Length of time it takes for the net cash inflows to pay back the original capital cost of the investment.
Payback period
Why do managers use the payback method to compare different projects?
To compare how quickly different projects recover their initial investment and rank them.
A $5,000 investment has an annual rate of return of 12%. How much profit does it generate in one year?
$600
Which cash flow year is NOT discounted when calculating NPV
Year 0
Why can managers not rely only on numerical results when making investment decisions?
Because numerical results ignore important considerations that can have a crucial impact on the final decision.
Evaluating the profitability or desirability of an investment project.
Investment appraisal
Give one advantage of using the payback method.
It is quick and easy to calculate.
• It is easy for managers to understand.
• It focuses on short-term cash flows, which are more reliable.
• It is useful when liquidity is important.
An investment grows from $10,000 to $11,500 in one year. What is the annual rate of return?
15%
If a project has a positive NPV, what decision should a business make?
Accept the project
Which factor may discourage a business from going ahead with an investment due to long-term effects on image and sales?
Possible negative publicity.
Measures the annual profitability of an investment as a percentage of the capital cost.
Accounting rate of return (ARR)
Project A costs $18,000 and generates $6,000 per year.
Project B costs $20,000 and generates $5,000 per year.
Using the payback method, which project should be chosen and why?
Project A
Payback A = 3 years
Payback B = 4 years
How much more money does a $20,000 investment earn in one year at annual rate of return of 8% compared to 6%?
$400 more
Why can changing the discount rate significantly affect the final NPV result?
Because a higher discount rate reduces the present value of future cash flows
Which consideration may prevent an investment from going ahead if local communities oppose the project?
Planning permission and opposition from local communities.
Today's value of the estimated net cash flows resulting from an investment.
Net present value
A project needs $100,000 to recover its initial investment at the start of Year 3.
The expected cash inflow during Year 3 is $200,000, how much time will it take to payback?
2 years an 6 months
$100,000 ÷ $200,000 = 0.5 × 12 months = 6 months
An investment from $8,000 to $8,800 in one year while inflation is 5%. Was the real return positive or negative?
Positive
How does a higher discount rate affect the NPV of a project?
A higher discount rate reduces the present value of future cash flows, which lowers the NPV
Why might managers reject an investment even if the numerical results are positive?
Because the project may not align with the business’s aims and objectives or because managers are unwilling to accept the level of risk involved.