Investment Appraisal - AS “Investment appraisal means evaluating the profitability or desirability of an investment project”

Investment appraisal These are quantitative techniques to help asses the financial feasibility of the project.  Payback period  Average rate of return  Net Present Value

What information is necessary? The initial cost of the investment. The estimated life expectancy. The residual value – what it will be sold for at the end of its useful life. The forecasted net returns or net cash flows from the project. (Forecasted inflow – forecasted outflows) These methods rely heavily on estimates.

Quantitative methods Payback method The payback period is the length of time it takes for the net cash inflow to pay back the original investment. For example if a project costs $1m and is expected to pay back $250,000 per year the payback period will be 4 years.

What is the pay back period? YearAnnual net cash flow ($) Cumulative cash flow ($) 0(500,000) 1300,000(200,000) 2150,000(50,000) 3150,000100, ,000 inc. residual value 200,000 Which month of the 3 rd year is the payback complete? 4 th month of the 3 rd year. $50,000 owed at the end of year 2. $150,000 is expected to be earned and $50,000 is a third of $150,000.

Why is payback of a project considered to be important? Managers can compare projects payback The shorter the payback the less interest will be charged if the money is borrowed. If the capital is generated internally there is the opportunity cost, it could be used in other projects. Businesses want a speedier return. If it take a long time to payback then more external influences can effect the business. Risk averse managers want a quick payback.

AdvantagesDisadvantages Quick and easyDoes not measure overall profitability of an investment Easily understoodMay reject very profitable investments Emphasis on speed of returnLots of external factors that cannot be controlled PESTL Can be used to eliminate investments which take too long to payback Useful for businesses where liquidity is important

Evaluation of Payback Payback method is often used as a quick check on the viability of a project or as a means of comparing projects. However, it is rarely used in isolation from other investment appraisal methods.

Questions 1. The table show the initial investment and the future cash outflows: 2. Calculate the payback period for the two projects. 3. Explain which project should be selected if payback is the only criterion used. 4. Why might the other project be chosen instead? YearProject XProject Y 0($50,000)($80,000) 1$25,000$45,000 2$20,000$35,000 3$20,000$17,000 4$15,000 5$10,000 REMEMBER – you need to calculate your cumulative cash flows first!

Payback for project X = 2 years and 3 months [number of months into the third year = 5,000 ÷ 20,000 × 12] Payback for project Y = 2 years

Average Rate of Return ARR measures the overall profitability of an investment as a percentage of the initial investment. There are 4 steps involved: 1. Add up all of the positive cash flows. 2. Subtract the cost of the investment. 3. Divide this figure by the life span of the investment in years. 4. Calculate what percentage this figure is of the initial capital cost using this formula: average annual profitx100 initial capital cost

Use the 4 steps for this example 1. Add positive cash flows = $9m 2. Subtract cost of investment = 9m – 5m = $4m 3. Divide by life span = $4m/4years = $1m 4. ($1m/$5m) x100 = 20% This indicates that on average, over the life span of the investment, it can expect an annual return of 20% on its investment. YearNet cash flow 0($5m) 1$2m 2 3 4$3m inc. residual value

The ARR can be compared to other ARR on other projects. Businesses can set the minimum expected return. For example the business may refuse to invest in projects with a return of less than 15%

AdvantagesDisadvantages It uses all of the cash flowsIt ignores the timing of cash flow. Could result in two projects with similar ARR results, but one could pay back more quickly than the other. Focuses on profitabilityLater cash flows which are less likely to be accurate are incorporated Result is easily understood and easy to compare The time value of money is ignored. Quick to asses against a criterion rate

Evaluation of ARR ARR is a widely used measure for appraising projects, but it is best considered with payback results. The two results the allow consideration of both profits and cash-flow timings.

Questions 1. Calculate the ARR for both projects. 2. The business has a cut- off criterion rate of 11% for all new projects. Would either be acceptable? 3. Taking both the results of payback and ARR together which project would you advise the business to invest in and why? YearProject XProject Y 0($50,000)($80,000) 1$25,000$45,000 2$20,000$35,000 3$20,000$17,000 4$15,000 5$10,000

Calculate ARR for both projects. [6] ARR = average profit ÷ initial investment × 100 For project X: profit = $40,000. Therefore, average profit = 40,000 ÷ 5 = $8,000. ARR = 8,000 ÷ 50,000 × 100 = 16% For project Y: profit = $32,000. Therefore, average profit = 32,000 ÷ 4 = $8,000 ARR = 8,000 ÷ 80,000 × 100 = 10%

NPV – Net Present Value The NPV is today’s value of the estimated cash flows resulting from an investment This method uses discount factors – these will be provided to you in an exam Interest rates and time are used to calculate discount factors (these exist in a standard table used by investors) 1) Multiply discount factors by the Net Cash Flow (except year 0 – these are today’s values) 2) Add the discounted cash flows 3) Subtract the capital cost to give the NPV

NPV – Net Present Value YearCash FlowDiscount 8% Discounted cash flows (DCF) 0($10,000)1 15, ,650 24, ,440 33, ,370 42, ,480 DCF = 11,940 Take away from the initial investment of 10,000 NPV = $1,940

NPV – Net Present Value NPV = $1,940 So, what does this mean? The investment (or project) earns $1,940 cash flow in today’s money values. So, is the investment worth it? If the $10,000 borrowed comes with an interest rate of less than 8%, it will be profitable So, why is it imperative that a business chooses the right Discount Rate? If interest rates are set to increase in the future, it could further reduce the level of cash inflows (so the project might not be worth doing!) So a business will chose a discount rate as near as possible to the lenders Why should they still use the discount rate if the finances are raised internally? OPPORTUNITY COSTS of the investment