Investment Appraisal: Payback Period Accounts and Finance Investment Appraisal: Payback Period

What is investment? TASK: Write your own definition of ‘investment’ in your workbook. Provide at least 3 examples of investment.

Yield: the rate of return Definition Investment refers to the purchase of an asset with the potential to yield financial benefits What’s ‘yield’? Yield: the rate of return

Investment Appraisal The term that refers to the techniques used to calculate financial costs and benefits of an investment decision Four main methods of investment appraisal: Payback Period Accounting Rate of Return Discounted Cash Flow Net Present Value

Payback Period The payback period refers to the period of time to repay the cost of the initial investment Calculation: initial investment ($) contribution per month ($/period) The amount you expect this investment to make each month (after maintenance/taxes/etc)

Let’s try it... Calculation: initial investment ($) contribution per month ($/period) Scenario: a firm thinks about buying a new truck. It will cost $10 000 to buy. After insurance, servicing, and running costs, it is anticipated that the truck will make the firm $6000 per year ($500 per month). We work the payment period out like this: $10 000 $500 PAYBACK PERIOD = 20months

Is it worth it? Firms will mostly only undertake investment projects if the payback period is relatively short. That is, there is no point in investing in something if it will be obsolete before the payback period.

Advantages Simple and quick Good for firms who have cash flow problems; allows them to easily see when they will regain money Firms can see if they will break-even on a purchase before it needs to be replaced Different projects and their costs can be easily compared Allows a firm to see what investment will get a good return for shareholders Less room for error ad the assessment is only for short term

Disadvantages May create a situation that encourages managers to only consider short term benefits when really they should be considering the long term benefits as well Contribution per month is unlikely to remain constant, due to changes in demand pattern. This could result in the payback period being longer than first anticipated Focuses on time rather than profit, and profit is the main aim of most businesses

Homework Chelsea Football Club CFC has gained a lot of titles since Russian oil tycoon Roman Abramovich took over the club in June 2003. He poured an estimated 440 million pounds into the club that year. Abramovich had no intention of cutting back either as he released a further 240 million pounds for the purchase of new players in 2006. However, huge financial losses have weighed down CFC, with reported annual losses of 140 million pounds, 88 million pounds and 80 million pounds in his first three years as owner of the club. CFC estimated that they would break even by 2010. Identify two factors that might have influenced Roman Abramovich’s decision to buy CFC. (2) Explain using the case study why investment can be risky. (4 marks) Comment on how application of the payback period might be useful for CFC. (4 marks)

Homework Answers: Reasons could include: the potential for CFC to return healthy profits; CFC may have been undervalued at the time of purchase; Abramovich could simply be a big fan of the club, i.e. Personal interest. There is no guarantee that CFC would become profitable; Abramovich had spent a lot of his own money on the club; CFC were suffering from ‘huge financial losses’ so Abramovich is taking a risk by investing in such a business; the club was not estimated to break-even until some 7 years after Abramovich took over the business. Start with defining the payback period. It would inform Abramovich how long it would take (as an estimate) before his spending on the club would generate enough revenue to pay back the value of the investment; a shorter payback period would tend to reduce the risk of such an investment project. Ultimately, it acts as a decision-making tool for risk assessment.