INVESTMENT APPRAISAL

INVESTMENT Refers to the purchasing of capital goods such as equipment, vehicles and new buildings; and improving fixed assets

INVESTMENT APPRAISAL Evaluating the profitability or desirability of an investment project. It assesses the economic viability of potential investment options so as to arrive at the most acceptable alternative depending on the criteria used for comparing these projects

INVESTMENT APPRAISAL TECHNIQUES Payback Period - Uses Cash Flows Average Accounting Rate of Return (ARR / AARR)- Uses Net Profit Net Present Value (NPV) - Uses Cash Flows Internal Rate of Return (IRR) - Uses Cash Flows

PAYBACK PERIOD This is the length of time necessary to recover the entire cost of an investment from the resulting annual net cash flows. Payback Period = (Number of years before recovery of initial investment) + ([Amount of investment remaining to be recaptured / Total cash flow during year of payback] x 12)

EXAMPLE The following refers to information relating to the investment in two projects: YEAR PROJECT A PROJECT B 0 (Initial Investment) ($500,000) 1 $300,000 $10,000 2 $200,000 $20,000 3 $50,000 4 $135,000 5 $5,000

CALCULATING PAYBACK PERIOD Calculate cumulative cash flow YEAR PROJECT A PROJECT A CUMULATIVE CASH FLOW PROJECT B PROJECT B CUMULATIVE CASH FLOW ($500,000) 1 $300,000 ($200,000) $10,000 ($490,000) 2 $200,000 $0 $20,000 ($470,000) 3 $50,000 ($270,000) 4 $60,000 $135,000 ($135,000) 5 $5,000 $65,000

CALCULATING PAYBACK PERIOD cont’d Payback will occur where the cumulative cash flow is equal to zero (0). Project A – Payback period is 2 years. (Straightforward) Project B – Payback Period = 4yrs and ? (To Calculate) ? = (Amount of investment remaining to be recaptured / Total cash flow during year of payback) x 12 = ($135,000/ $200,000) x 12 = 8.1 months Final Answer is 4yrs and 8.1mths

ADVANTAGES OF PAYBACK METHOD It is easy to calculate and understand It focuses on risk and therefore promotes prudence and caution By focusing on liquidity (cash flow) rather than profitability, this method is looked upon favorably by lenders of capital

DISADVANTAGES OF PAYBACK METHOD It fails to take into account cash flows after the payback period It does not take into consideration the time value of money It only looks at cash flows and does not consider overall profitability

Average Accounting Rate of Return (AARR / ARR) Unlike other appraisal methods, the ARR uses profit instead of cash flows. This method therefore give profitability of the investment as a percentage of the initial investment. The usual difference in a question between cash flow and profitability is depreciation. In order to arrive at profit when given cash flows, you need to minus depreciation per year from the cash flows.

AARR / ARR EQUATION ARR = (Average Annual Profit /Initial Investment) x 100

CALCULATING ARR /AARR Calculate profit if depreciation per year is $10,000 for Project A and $15,000 Project B YEAR CASH FLOW PROJECT A PROFIT PROJECT A CASH FLOW PROJECT B PROFIT PROJECT B ($500,000) 1 $300,000 $290,000 $10,000 ($5,000) 2 $200,000 $190,000 $20,000 $5,000 3 $50,000 $40,000 $185,000 4 $0 $135,000 $120,000 5 Total $515,000 $490,000

CALCULATING ARR /AARR cont’d Project A = [($515,000/5) / $500,000] x 100 = ($103,000 / $500,000) x 100 = 20.6% Project B = [($490,000/5) / $500,000] x 100 = ($98,000 / $500,000) x 100 = 19.6%

ADVANTAGES OF AARR / ARR It focuses on profitability in all years unlike payback It focuses on profitability, which is the central objective of many business decisions The result is easy to understand and compare with other projects

DISADVANTAGES OF AARR / ARR It ignores the timing of profit flows. This could result in two projects having the same ARR but with different paybacks The time value of money is ignored

NET PRESENT VALUE (NPV) This method takes into consideration the fact that future cash flows will lose value over time. This method therefore discounts all future cash flows and brings them to present values. (Using a Present Value Interest Factor [PVIF] table) This summed total of all of the Present Values is then subtracted from the initial investment in order to calculate the Net Present Value. The project with the highest positive NPV would be chosen.

CALCULATING NPV PROJECT A YEAR CASH FLOW 10% DISCOUNT FACTOR PRESENT VALUE ($500,000) 1 $300,000 0.9091 $272,730 2 $200,000 0.8264 $165,280 3 $50,000 0.7513 $37,565 4 $10,000 0.6830 $6,830 5 $5,000 0.6209 $3,104.50 NPV ($14,490.50)

CALCULATING NPV PROJECT B YEAR CASH FLOW 10% DISCOUNT FACTOR PRESENT VALUE ($500,000) 1 $10,000 0.9091 $9,091 2 $20,000 0.8264 $16,528 3 $200,000 0.7513 $150,260 4 $135,000 0.6830 $92,205 5 0.6209 $124,180 NPV ($107,736)

ADVANTAGES OF NPV It takes into account the time value of money It considers the cash flows for the entire project

DISADVANTAGES OF NPV It is more complicated to calculate The discount rate is only an estimate, this could change at any moment

INTERNAL RATE OF RETURN (IRR) Attempts to find the discount rate where NPV is equal to zero.(ie. When the cost or initial investment = discounted cash flows). This rate is then compared to the interest rate which is charged when borrowing to invest (Cost of Capital)If that rate is more than the cost of capital then the project should be profitable. The IRR is therefore the rate at which the company internally generates profit on its investment. (Not required to work it out for exams)