Investment appraisal What is “Investment”? Investment appraisal Using quantitative analysis to analyse whether a capital investment is worthwhile All about CAPITAL COST vs NET CASH FLOW For strategic or medium term objectives not tactical decisions.

Methods of Investment Appraisal Three methods Payback How many years and months before the initial cost of the investment is paid back Average rate of return (“ARR”) The average annual profit as a percentage of the initial investment. Comparable with ROCE Net present value (“NPV”) Total return from an investment in today’s money (taking into account that money received in the future is worth less than money now)

Payback Measures the length of time it takes to pay back the original cost of an investment in a new printing machine Look at initial investment, then annual cash inflows and outflows, for example with a printing machine costing £750,000 Use the information in the first table to complete the second Year (£) Cash in Cash out Net cash flow per year Cumulative Cash Flow 1 2 3 4 5 Total Note the initial investment is deemed to take place in year 0 £ Machine A Initial cost 750,000 Inflows: Year 1 180,000 Year 2 220,000 Year 3 250,000 Year 4 Year 5 275,000 Maintenance 10,000 per year

Net cash flow (£) per year Payback Year Cash out (£) Cash in (£) Net cash flow (£) per year Cumulative Cash Flow 750,000 (750,000) -750,000 1 10,000 180,000 170,000 -580,000 2 220,000 210,000 -370,000 3 250,000 240,000 -130,000 4 110,000 5 275,000 265,000 375,000 Total 800,000 1,175,000 When does the investment of £750,000 get paid back? Add up all the cash flows cumulatively until you make a profit The investment is paid back in the 4th year - When in the 4th year? Net cash flow in year 4 is £240,000, or £20,000 per month (assume spread evenly) Require £130,000, so need £130,000/£20,000 which is 6.5 months So payback is 3 years 6.5 months

Payback Very Simple Method Shortcut: If cash flows are constant (eg £360,000 per year for a capital cost of £750,000), then: Payback = sum invested/net cash flow. Answer is 2 years and 1 month (how did we work it out?) May be given outflows and inflows, or costs and revenues. Need to work out net cash flow and put into a table Always put investment in Year 0, then work out net inflow for the following years Nearly always based on a finite time period Most machinery is expected to last a certain time (and is depreciated) Note that whilst questions are based on a finite period, some investment may add value over a longer period, eg opening a new store Very Simple Method

Payback example A local garage is considering buying a machine which can refill (re-gas) the air-conditioning units of customer cars. The estimated costs and revenues are as follows: The garage estimates the number of customers requesting the air-conditioning service to be: Calculate the payback period Cost of machinery £10,000 Cost of gas per service £15 Wages and other costs per service Price charged per service £80 Year 1 40 Year 2 60 Year 3 Year 4 Year 5 Year 6 30

Payback example answer First need to fill in cash out and cash in, complicated by needing to calculate Make a positive cumulative Cashflow by the 4th year In year 4 cash flow is £3,000 or £250 per month, but we just need £2,000. So we need £2,000/£250 months Payback is therefore 3 years 8 months Year Cash out (£) Cash in (£) Net cash flow (£) Cumulative 10,000 (10,000) 1 1,200 3,200 2,000 (8,000) 2 1,800 4,800 3,000 (5,000) 3 (2,000) 4 1,000 5 6 900 2,400 1,500 4,500 Total 18,700 23,200

(Total net return/number of years) Average rate of return We can calculate when an investment is paid back, but does that make it worthwhile? Really looking for a high rate of return on the investment (remember Unit 2????) Need to make sure the return covers the cost of borrowing if using a bank loan, or if there are other better investments Use average rate of return (ARR) ARR (%)= x 100 (Total net return/number of years) Initial investment

(Total net return/number of years) Example Add up Total Net Cashflow (Done -> £20,000) Divide by the number ofyears toget average return / year = £20,000 / 5 = £4,000 average return per year ARR% = £4,000 x 100 = 8% £50,000 (Total net return/number of years) Initial investment X 100 ARR(%) = What would the ARR% be for the above project with returns of £20,000 each year (Years 1 to 5)?

ARR Calculate for printing machine Calculate for air-conditioning machine

Net present value (NPV) – sometimes called the time value of money or TVM approach Quite sophisticated, and only larger businesses will use this ARR does not take into account when the cash flows take place Are cash flows received in 5 years worth the same as cash flows or payments this year? Idea is that £1 today has more value than £1 in the future This is because of the opportunity cost of money – can do something with the £1, such as earn interest. Also, money today is certain, whilst there is always risk about receiving money in the future For example, at an interest rate of 10%, £100 becomes £110 after 1 year In this case, the present value of £110 received in a year’s time is £100

NPV If you could earn 10% interest by putting money in the bank, which of the following would you prefer: £1,000 today or £1,150 in 2 year’s time? £50 today or £65 in 3 year’s time? £1,000 + 10% of £1,000 is £1,100 in a year’s time, £1,100 + 10% of £1,100 is £1,210 in 2 year’s time Formula is £1,000 x (1 + 10%) x (1+10%) or £1,000 x (1+10%)2 which is £1,000 x 1.12 Advanced: general formula is £1 becomes £1 x (1 + r)n where r is the rate of interest, and n is the number of years

Example Discount Factors

NPV & Discount Factors So putting in reverse, what is £1,150 due in 2 years, worth in today’s money if interest rates are 10% Easiest to calculate a discount factor using £1 DF = 1__ = __1___ = 0.83 (1 + r)n (1 + 0.10)² So the present value of every pound in 2 year’s time is £0.98 today, which means £1,150 in 2 year’s time is worth £1,150 x 0.83 = £950 10% is called the discount rate and 0.83 is called the discount factor Present value is future net cash flow times the discount factor Exam questions will give the discount factor you should use

NPV example Simple example: Invest in a machine for £100m, with the following cash inflows and outflows, and with the following discount factors (based on a discount rate of 10%): Year Cash out (£m) Cash in (£m) Net cash flow (£m) Discount factor Present value (£) 100 (100) 1 10 60 50 0.91 46 2 20 80 0.83 3 30 70 0.75 53 Total 160 240 48 discount factor Net cash flow times equals present value

NPV practice NPV of printing machine Year Cash out (£) Cash in (£) Net cash flow (£) Discount factor Present value (£) 750,000 (750,000) 1 10,000 180,000 170,000 0.91 154,700 2 220,000 210,000 0.83 174,300 3 250,000 240,000 0.75 4 0.68 163,200 5 275,000 265,000 0.62 164,300 Total 800,000 1,175,000 375,000 86,500

NPV practice NPV of printing machine Year Cash out (£) Cash in (£) Net cash flow (£) Discount factor Present value (£) 750,000 (750,000) 1 10,000 180,000 170,000 0.91 154,700 2 220,000 210,000 0.83 174,300 3 250,000 240,000 0.75 4 0.68 163,200 5 275,000 265,000 0.62 164,300 Total 800,000 1,175,000 375,000 86,500

NPV NPV is particularly useful comparing alternative projects/investments as follows Can also use different discount rates (discount factor) to take into account riskiness of projects £m Project 1 Project 2 Year Net cash flow Discount factor Present value (100) 1 20 0.91 18.2 80 72.8 2 40 0.83 33.2 60 49.8 3 0.75 30.0 30 22.5 4 0.68 27.2 13.6 5 0.62 49.6 10 6.2 Total 120 58.2 100 64.9 ARR 30% 25% Payback 3 years 1 year 4 months

The 3 methods Advantages Disadvantages All Scientific methodology rather than guesswork Relies on forecasts, which may be inaccurate – particularly the further into the future they are made Payback Easy to understand Easy to calculate, particularly useful if comparing many projects By emphasising the speed of return it is popular with firms operating in changing markets Ignores cash flows which take place after the payback period has been reached Hard to establish a payback period – factories may take longer to pay back than a marketing campaign, but still be valuable Values future cash flows the same as present ones ARR Easy to calculate The result can be compared with the next best alternative, eg interest rate Shows true profitability of an investment A bit harder to calculate than payback Values all cash inflows and outflows the same, whenever they take place (including very uncertain long term forecasts) NPV Only method which considers the time value of money Only method which gives an answer – positive NPV means a project is worthwhile Cash flows a long time in the future are uncertain (risky) and are given less weight Conceptually difficult to understand which bosses may mistrust Hard to calculate Depends on the choice of discount rate – which may be arbitrary