3.2 Investment Appraisal To begin: Research and come up with a definition for Investment Appraisal that a year 9 will understand 3 minutes

3 to 4 I can calculate ARR and/or Payback 5 to 6 I can explain the results of the calculations 6 to 7 I can analysis and evaluate the results and make suggestions Learning intention: To be able to explain AND use the quantitative appraisal methods of Accounting Rate of Return and Payback

So what is investment? Discuss what investing is and why businesses invest How does this compare to your definition from the starter? Investment Appraisal is a broad term used to describe the quantitative methods used to calculate the financial cost and benefits of an investment decision

PAYBACK PERIOD Simply – how long it takes for a project to payback the cost of the initial investment What might be the formula? initial investment $ contribution per month $

Have a go… A firm wants a new photocopier for $10,000. It would gain $6,000 revenue per year. What is the payback period in months? Payback = $10,000 for purchase ($6,000 / 12 months) 20 months

Investment Appraisal using PB When assessing whether to carry out an investment businesses would have to balance : – the initial cost against the benefits of such investment. What criteria can be used to judge whether long – term investment is worth carrying out? The business may consider: – how quickly the investment is recouped ( Payback) – the effect of redundancies on the work – force and – perhaps the need for training to use new machinery

How are investments assessed? The Payback Method One method of measuring the success of any proposed investment is to calculate how quickly the cost of the investment can be recouped. The quicker the payback period the better. Project AProject B Cash Flow End of Year , ,000 EOY 1 20,000 40,000 EOY 2 30,000 30,000 EOY 3 40,000 20,000

PAYBACK PERIOD Simply – how long it takes for a project to payback the cost of the initial investment What might be a formula? initial investment $ contribution per month $

Have a go… A firm wants a new photocopier for $10,000. It would gain $6,000 revenue per year. What is the payback period in months? Payback = $10,000 for purchase ($6,000 / 12 months) 20 months

How are investments assessed? Cash flow, means revenue minus operating cost, assuming all transactions are in cash. This does not include the investment costs. End of year means that the cash flow comes into the business by the end of the year. Payback is the amount of time that it takes for investment to be repaid. See worked example on pg 351 of Hoang Text

Cumulative Cash Flows YearsCash Flow Cumulative Cash Flow Cumulative Cash Flow – owed/profit EOY 0-29,7000 EOY 1 11, ,400 E0Y 2 12,90024,200-5,500 EOY 3 15,20039,4009,700 EOY 4 10,40040,80020,100 EOY 5 5,10045,90025,200 The Payback period will be by the end of year 3, that is, when the cumulative cash flow is positive Your task: Calculate the exact payback period in months.

Answer 1 – Find difference between amount invested and cumulative net cash flow for yr prior to pay off: 29, ,200 = 5,500 2 – Calculate av monthly cash flow for year of pay off 15,200/12 = $1, – Divide amount owed by monthly amount 5,500/1, = 4.34

Question Calculate the payback for an investment costing $100,000, which earns cash flows of: $ EOY 110,000 EOY 220,000 E0Y 350,000 EOY 460,000 EOY 560,000

Question For the following two projects, calculate the payback period. Recommend which project to choose. Project AProject B EOY EOY EOY E0Y EOY EOY Cash Flow ($000)

Timing of the Cash Flow YearsProject A Project B EOY 0-12,000 EOY 14,0006,000 E0Y 24,0003,000 EOY 34,0003,000 EOY 44,0003,000 EOY 54,0003,000 Note: Both projects have the same payback but in different ways. If a business is attempting to decide between two projects, it may choose B on the grounds that the earlier cash flows occur in 1 year. This could be very significant to the liquidity position of the business. However, no account is taken of any cash flow after the payback period. Although according to the payback method, projects have the same payback, the cash flow after the payback period makes Project A more attractive. Note: Both projects have the same payback but in different ways. If a business is attempting to decide between two projects, it may choose B on the grounds that the earlier cash flows occur in 1 year. This could be very significant to the liquidity position of the business. However, no account is taken of any cash flow after the payback period. Although according to the payback method, projects have the same payback, the cash flow after the payback period makes Project A more attractive.

Question Each of the projects involves a cost of 1 million dollars, but produces a net cash flow as shown: YearsProject A Project BProject C EOY E0Y EOY EOY EOY Using a payback rule of: a) two years b) three years Which projects are worth while? 2. Rank the projects in terms of payback period.

Advantages and Disadvantages of the Payback Method Advantages Its simple to use. Its easy to understand. It’s the appropriate method to use if there is concern over liquidity problems. It’s a useful initial ‘test’ as to the validity of an investment. It’s a valuable assessment of the risk involved. Advantages Its simple to use. Its easy to understand. It’s the appropriate method to use if there is concern over liquidity problems. It’s a useful initial ‘test’ as to the validity of an investment. It’s a valuable assessment of the risk involved. Disadvantages Payback fails to take into account any of the cash flows after the payback period. It takes no account of the value of money over time. It does not consider the profitability of the investment. Disadvantages Payback fails to take into account any of the cash flows after the payback period. It takes no account of the value of money over time. It does not consider the profitability of the investment. There is therefore a need to find a method of calculating a more realistic value for the likely return on the proposed investment. NEXT WEEK!

Homework 3.2.2, P.353 For next week, Joe, its all about Chelsea!