Investment Appraisal

Homework Plan an activity on investment appraisal for the class. Plan a 10 minute lesson which makes use of the activity. You should include: definitions/formula/explanations on how to carry out the method/the advantages and disadvantages of the method/why qualitative data should be used in partnership with investment appraisal.

What is investment appraisal? Investment Appraisal is the use of scientific decision-making tools to analyse whether a proposed future investment should go ahead. There are 3 techniques that all involve a comparison of the cost of investment project with the expected return in the future.

The three techniques Payback The time taken to recover the initial cost of the investment. Average Rate of Return (ARR) The profits earned on investment expressed as a % of the cost of initial investment. Net Present Value (NPV) The total returns from an investment in today’s terms.

Learning objectives Define, apply and critique two methods of investment appraisal: Payback Average Rate of Return

Payback Payback measures the time it will take to payback the initial cost of the investment. This includes calculating the year and month in which it will be paid back. Payback is the most commonly used by businesses due to its simplicity. However, rarely used on its own.

Payback Very important to a business with cash flow problems Also if the business is investing in equipment that may become out-of-date quickly. May be important if the business is run on external sources of finance.

Payback example A company plans to buy a new machine costing £500,000 Year Cash out Cash in Net Cash Flow 1 2 3 4 5 A company plans to buy a new machine costing £500,000 It will bring in new revenues of £100,000 the following year and then £150,000 for each of the following four years. There will maintenance costs of Year 3: £20,000 Year 4: £30,000 Year 5: £50,000 How long will it take to repay the initial investment? 8

Payback example A company plans to buy a new machine costing £500,000 Year Cash out Cash in Net Cash Flow £500,000 (£500,000) 1 £0 £100,000 2 £150,000 3 £20,000 £130,000 4 £30,000 £120,000 5 £50,000 A company plans to buy a new machine costing £500,000 It will bring in new revenues of £100,000 the following year and then £150,000 for each of the next four years. There will maintenance costs of Year 3: £20,000 Year 4: £30,000 Year 5: £50,000 How long will it take to repay the initial investment? 9

Payback example Year Cash out Cash in Net Cash Flow £500,000 (£500,000) 1 £0 £100,000 2 £150,000 3 £20,000 £130,000 4 £30,000 £120,000 5 £50,000 £110,000 We determine the payback period by calculating the cumulative next cash flow until the initial outlay is paid off. YEAR 1 £100,000 YEAR 1 + YEAR 2 £100,000 + £150,000 = £250,000 YEAR 1 + YEAR 2 + YEAR 3 £100,000 + £150,000 = £130,000 = £380,000 YEAR 1 + YEAR 2 + YEAR 3 + YEAR 4 £100,000 + £150,000 + £130,000 + £120,000 = £500,000 Investment of £500,000 is paid back in year 4 10

It’s never that easy! Most payback problems require you to calculate the specific month of payback as well as the year. How do we do this?

Payback example: Machine A Year Cash out Cash in Net Cash Flow £750,000 (£750,000) 1 £7,500 £150,000 £142,500 2 £200,000 £192,500 3 £260,000 £252,500 4 5 £300,000 £292,000 Step 1: Find the year of payback Add up net cash flows year by year until the cumulative net cash flow exceeds the initial investment YEAR 1 £142,500 YEAR 1 + YEAR 2 £142,500 + £192,500 = £335,000 YEAR 1 + YEAR 2 + YEAR 3 £142,500 + £192,500 + £252,500 = £587,500 YEAR 1 + YEAR 2 + YEAR 3 + YEAR 4 £142,500 + £192,500 + £252,500 + £252,500 = £840,000 Since the investment of £750,000 is more than the cumulative net cash flow in year 3 but less than in year 4, we know that the investment is paid back sometime in Year 4. On to step 2… 12

Payback example: Machine A Year Cash out Cash in Net Cash Flow £750,000 (£750,000) 1 £7,500 £150,000 £142,500 2 £200,000 £192,500 3 £260,000 £252,500 4 5 £300,000 £292,000 Step 2: Find the month of payback which the investment is paid back a) Calculate remaining cash required £750,000 - £587,500 = £162,500 At end of year 3 b) Divide remaining cash required by net cash flow for that year and multiply by 12 £162,500 £252,500 = 0.644 x 12 = 7.728 months c) Round up to next month d) Add back the number of years Payback period is 3 years and 8 months 13

Payback The shorter the payback period the less risk there is involved in the project and the quicker the business start to generate profit from the investment.

Disadvantages of payback Doesn’t take into account the business’ profitability. Doesn’t take into account additional cash inflow after the payback period Assumes steady inflows throughout the year. Exam Help: Try and think of payback in relation to the business, such as expected lifespan of the project, seasonality and cash flow situation. 15

Activity Calculate payback period for Machine B Which is the best investment?

Payback example: Machine B Year Cash out Cash in Net Cash Flow £310,000 (£310,000) 1 £15,000 £125,000 £110,000 2 £127,000 £112,000 3 £140,000 4 5 £130,000 £115,000 Step 1: Find the year of payback Add up net cash flows year by year until the cumulative net cash flow exceeds the initial investment YEAR 1 £110,000 YEAR 1 + YEAR 2 £110,000 + £112,000 = £222,000 YEAR 1 + YEAR 2 + YEAR 3 £110,000 + £112,000 + £125,000 = £347,000 Since the investment of £310,000 is more than the cumulative net cash flow in year 2 but less than in year 3, we know that the investment is paid back sometime in Year 3. On to step 2… 18

Payback example: Machine B Year Cash out Cash in Net Cash Flow £310,000 (£310,000) 1 £15,000 £125,000 £110,000 2 £127,000 £112,000 3 £140,000 4 5 £130,000 £115,000 a) Calculate remaining cash required £310,000 - £222,000 = £88,000 At end of year 2 b) Divide remaining cash required by net cash flow for that year and multiply by 12 £ 88,000 £125,000 = 0.704 x 12 =8.448 months c) Round up to next month d) Add back the number of years Payback period is 2 years and 9 months 19

Learning objectives Define, apply and critique the Average Rate of Return as a method of investment appraisal:

Average Rate of Return (ARR) Assesses the value of an investment by calculating the average annual profit as a percentage of the initial investment cost. Therefore the formula is…

ARR formula x 100 = Average annual profit Initial investment Number of years* Total net cash flow Average annual profit = * The “life” of the asset

ARR example: Machine A Step 1: Calculate average annual net profit Year Cash out Cash in Net Cash Flow £750,000 (£750,000) 1 £7,500 £150,000 £142,500 2 £200,000 £192,500 3 £260,000 £252,500 4 5 £300,000 £292,500 Step 1: Calculate average annual net profit Total net cash flow Life of the asset £382,500 5 = = £76,500 Step 2: Divide average annual profit by the initial investment and multiply by 100 £76,500 £750,000 X 100 = 10.2% £382,500 23

ARR The higher the ARR the potentially profitable the investment. Allows easy comparison to other forms of investment like bank interest rates. It can be easily compared to the current or target ROCE.

Disadvantage of ARR Doesn’t take timing of the cash flow into account

Activity Calculate ARR period for Machine B Which is the best investment?

ARR for Machine B Step 1: Calculate average annual net profit Year Cash out Cash in Net Cash Flow £310,000 (£310,000) 1 £15,000 £125,000 £110,000 2 £127,000 £112,000 3 £140,000 4 5 £130,000 £115,000 Step 1: Calculate average annual net profit Total net cash flow Life of the asset £277,000 5 = = £55,400 Step 2: Divide average annual profit by the initial investment and multiply by 100 £55,400 £310,000 X 100 = 17.9% 28

Conclusion Machine A Machine B

Learning objectives Define, apply and critique two methods of investment appraisal: Payback Average Rate of Return

Confidence levels Payback Are you Cowell or Cole? ARR 5 5

Learning objectives Define, apply and critique two methods of investment appraisal: Payback Average Rate of Return

Net Present Value (NPV) Takes into account the total return from an investment in today’s terms. This is done using the DISCOUNT FACTOR The rate by which future cash flows are reduced to reflect the current interest rates.

NPV An another advantage of NPV is that is takes into account the This is the recognition of the fact that £1 today is worth more than £1 in the future. time value of money

Time value of money Suppose I have £10 today and I put that money in the bank for two years at an interest rate 10%. How much will I end up with in 2012? £10 x 10% x 10% = £12.10 Or more accurately, £10 x 1.1 x 1.1 = £12.10 This is compound interest. A shorter formula for compound interest is (1+0.1)2

Discount factor How would I find out how much £12.10 in two years’ time is worth today? In effect, it is the reciprocal of the compound interest formula And is known as the discount factor: = £12.10 x 1÷ (1+0.1)2 = £10.00 = £12.10 x 0.826446 = £10.00

NPV Example: Machine A

Calculate NPV for Machine B

NPV Example: Machine B 41

Conclusion Machine A Machine B

Net Present Value (NPV) If POSITIVE value then the project is profitable and is therefore WORTHWHILE If NEGATIVE value then the project is considered unprofitable and will be REJECTED

Advantages of NPV Takes account of whole life of the investment Takes into account net cash flows for whole period Takes account of the time value of money Takes account of the opportunity cost of the project

Disadvantages of NPV Quite complex and technical – not easily understood by non-financial managers Often inaccurate discount factor over time

Confidence on investment appraisal Payback Cowell or Cole? ARR NPV 5 5 5

Risks of investment decisions Sum to invest Source of funds Impact on rest of business Ability to reverse decision Impact of investment of future plans

Uncertainties of investment decisions Market stability – extent of change Competitor reactions Economic environment Accuracy of cash flow projections Projected life of investment decision

Qualitative factors Aims and objectives of the business Image- effect on reputation and brand Personnel: work habits, morale, culture etc. Consumer perceptions Effect on communities Production issues Cultural issues