3.2 Investment Appraisal Chapter 19

Investment To purchase capital goods  Equipment  Vehicles  New buildings  Improving existing fixed assets

Investment Appraisal Evaluating the profitability or desirability of an investment project  Quantitative Investment Appraisal Using techniques to study the financial issues of investment (think Qty-$$$)  Qualitative Appraisal Studying non-financial issues that may impact an investment decision (think Quality and Impact)

Qualitative Investment Appraisal Studying non-financial issues that may impact an investment decision  Impact on the environment  Bad publicity could harm company image and reduce sales  Planning permission may not be granted or be hindered by pressure groups  Aims and objectives of the business may be in opposition with project (a commitment to personalized customer service might hinder a project to computerize services)  Risk….No amount of positive data can alter some management decisions they feel are unwise.

Quantitative Investment Appraisal Requires the following information:  Initial cost of investment (including installation)  Estimated life expectancy (how many years can returns be expected from the investment)  Residual value (at the end of its useful life, can the asset be sold for additional $$)  Forecasted net returns or net cash flows from the project (money generated from the investment minus the annual running cost)

Quantitative Investment Appraisal Three Methods Payback Period Length of time required for net cash flows to pay back the original capital cost of the investment Average Rate of Return Annual profitability of an investment as a percentage of the initial investment Net Present Value Today’s value of the estimated future cash flows resulting from an investment

Forecasting Cash Flows Cash Inflow Annual Revenues minus Cash Outflow Annual Operating Costs = Net Cash Flow Problems occur when forecasting the future because no one can predict what external forces will effect cash flows. This can make cash flow projections inaccurate. Manager must take this into consideration.

Payback Method Length of time required for net cash inflows to pay back the original capital investment. Managers compare the payback period to alternative projects to put them in priority order.

Payback Method- Considerations to Evaluate A business could borrow the investment money….longer payback time means more interest payments. Opportunity cost of money – what other projects could be funded. The longer the payback period the more likely external factors could be a problem and are likely unpredictable. Managers can be “risk averse” – faster payback is less risky by reducing uncertainty Long payback can reduce the value of money by inflation.

Average Rate of Return (ARR) Measures the annual profitability of an investment as a percentage of the initial investment. Annual Profit (Net Cash Flow) Initial Capital Cost ARR% = X 100

Why is ARR Important? You can compare ARR on multiple projects. Criterion Rate – a company may only accept projects that meet or exceed a certain ARR Rate…say 15% or more. Annual interest rate on loans needs to be considered….if the ARR is 5% and the interest rate on money to fund the project is 12%, it is not worth making the investment

Net Present Value (NPR) Measures the “time value of money”…cash received in the future is not as valuable as cash received today.  Money received today can be spent today without waiting  Money received today can be invested and worth more than the same money received in the future $1000 today +$100 interest = $1100 vs $1000 in the future  Money received today is certain, future money is not guaranteed  Inflation makes money received in the future worth less than money received today HL

Net Present Value (NPR) Discounting Future Cash Flows The NPR of future money depends on 2 things:  The higher the interest rate, the less value future cash has in today’s money  The longer into the future cash is received, the less value it has today HL

Net Present Value (NPR) How do you calculate NPR: $3000 is expected in 3 year’s time. 10% current interest rate. (Interest rate is also the discount rate) Apply the discount factor of.75 $3000*.75=$2250 is the NPR value today HL Year6%8%10%

Net Present Value (NPR) Evaluation NPR does not give a % rate of return so it usually is not considered by itself. It does consider both timing of cash flows and their amounts. The discount rate can be varied to allow for different circumstances. It can be complex and difficult to explain. Results are determined by the accuracy of the discount rate selected. NPR can only be compared with projects with the same initial capital cost since it is not percentage based. HL