Investment appraisal The basics Philip Allan Publishers © 2015

Investment appraisal There are three different tools a business can use to assess the merits of different investments: payback period average rate of return net present value Philip Allan Publishers © 2015

Payback period This is the amount of time it takes to recoup the cash outlay of the investment, e.g. The example above shows that option 1 pays back after 2 years as the £20,000 is recovered after two £10,000 cash inflows. However, option 2 is somewhere between years 2 and 3, so we use the following formula: Amount required10, × × 12 = 2 years 6 months Amount received20,000 Philip Allan Publishers © 2015 Option 1Option 2 Capital outlay (£)(20,000)(40,000) Net income year 1 (£) ,000 Net income year 2 (£)10,00020,000 Net income year 3 (£)10,00020,000 Net income year 4 (£)10,00040,000 Net income year 5 (£)10,00040,000

Average rate of return (1) This is a more meaningful and complex method of investment appraisal. It works out a % return for each investment and is a much more useful comparison to other tools such as ROCE. There are four simple steps: 1.Work out the total return of the project. 2.Subtract the cost of the project. This gives the net return. 3.Divide by the number of years. This gives the net return per annum. 4.Divide the net return per annum by the cost of the project and multiply by 100 (see worked example).

Average rate of return (2) Worked example Cost:(£100,000) Year 1:£50,000 Year 2:£50,000 Year 3:£50,000 Year 4:£150,000 Year 5:£150,000 Step 1: add up all cash flows = £450,000 Step 2: deduct outlay = £450,000 – £100,000 = £350,000 Step 3: divide by number of years = £350,000/5 = £70,000 Step 4: divide by outlay = £70,000/£100,000 and multiply by 100 = 70% return

Average rate of return (3) Advantages  Uses all the cash flows over the project’s life.  Focuses on profitability, unlike payback.  Easy to compare. Disadvantages  Ignores the timing of the cash flows (unlike NPV).  As later years included it could be argued to be less accurate than payback.  It’s only a forecast (can be very unpredictable).

Net present value (1)  If £100 now is worth £110 in a year’s time, it would be good to know how much £100 in a year’s time is worth today.  This method of investment appraisal takes into consideration the current value of the project to see whether it is worthwhile.  Net present value (NPV) calculates the present value of all the money coming into a business.  It uses something called a discount factor, which is basically an interest rate in reverse, e.g. £10,000 in 1 year’s time is worth £9,909 now.  In other words £9,909 invested now would be £10,000 in a year’s time.

Net present value (2) Worked example Outlay:(£40,000) Year 1:£10,000 × 0.91 = 9,100 Year 2:£10,000 × 0.83 = 8,300 Year 3:£10,000 × 0.75 = 7,500 Year 4:£10,000 × 0.68 = 6,800 Year 5:£10,000 × 0.62 = 6,200 I.e. year 1 cash flow is £10,000 but NPV theory tries to calculate the present value of that inflow, which is £9,100 With NPV applied, the total cash flows are £37,900 in present value. This is a negative return on the project (£2,100), so the project would be rejected.

Net present value (3) Advantages  Considers the time value of money.  Takes into account all years and therefore profitability. Disadvantages  Can be complex to calculate, though discount factors are given in the exam.  Can be quite negative, as most projects end up being rejected.  It’s only a forecast (can be very unpredictable).  The interest rates used are often unrealistic, e.g. 10% rates do not reflect reality.