1. 1 Investment Appraisal Techniques

2. Investment Appraisal 2 What do you understand by the term Investment Appraisal? Investment appraisal involves a series of techniques, which enable a business to financially appraise investment projects.

3. Investment Appraisal 3 It is a techniques use to determine if a particular investment is worthwhile. It can be used to compare different projects to determine which is more favourable.

4. 4 Types of Investment Appraisal Techniques?  Pay Back Period (PBP)  Net Present Value (NPV)  Internal Rate of Return (IRR  Accounting Rate of Return (ARR)

5. Pay Back Period This is defined by CIMA as 'The time required for the cash inflows from a capital investment project to equal the initial cash outflow(s) It simply means the time it takes an investment to pay back the amount invested. The decision rule is that projects with the minimum pay back time are acceptable. 5

6. Disadvantages of the payback method It ignores the timing of cash flows within the payback period. It also ignores the cash flows after the end of the payback period and therefore the total project return. It ignores the time value of money. This means that it does not take account of the fact that £1 today is worth more than £1 in one year's time. The method is unable to distinguish between projects with the same payback period. It may lead to excessive investment in short-term projects. 6

7. Advantages of the payback method Payback is an easily understood concept. The calculation is quick and simple Shorter-term forecasts are likely to be more reliable. It is a measurement of Investment risk as risk is increased if payback is longer. 7

8. Practice Question 8 Calculate the PBP for the two projects.

9. Accounting Rate of Return (ARR) Accounting Rate of Return (ARR) expresses the average accounting profit as a percentage of the capital outlay. The decision rule is that projects with an ARR above a defined minimum are acceptable; the greater the ARR, the more desirable the project. 9

10. The average investment is calculated as : (Initial investment + final or scrap value) 10 2 Calculating the accounting rate of return

11. Practice Questions 11

12. Disadvantages It is based on accounting profits rather than cash flows, which are subject to a number of different accounting policies. It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment. It takes no account of the length of the project. Like the payback method, it ignores the time value of money 12

13. Advantages It is quick and simple to calculate. It involves a familiar concept of a percentage return. Accounting profits can be easily calculated from financial statements. It looks at the entire project life 13

14. Net Present Value (NPV) This takes into account the time value of money. It is based on the principle that money is worth more than it is in the future. The principle exists for two reasons: 14 Risk – money in the future is uncertain. Opportunity cost –could be in an interest account earning interest.

15. Net Present Value (NPV) NPV = present value of cash inflows minus present value of cash outflows. 15  If the NPV is positive, it means that the cash inflows from a project will yield a return in excess of the cost of capital, and so the project should be undertaken.  If the NPV is negative, it means that the cash inflows from a project will yield a return below the cost of capital, and so the project should not be undertaken. NPV=PVCI-PVCO  If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly the same as the cost of capital.

16. Advantages Considers the time value of money. It considers all relevant cash flows, so that it is unaffected by the accounting policies which affects profit-based investment appraisal techniques such as ARR Reducing discounting rate reduces future monies more heavily. Only one method that gives a definitive answer. Positive return – it is worth doing 16

17. Disadvantages Time consuming. More difficult to understand. Based on an arbitrary choice of interest rate. 17

18. Practice Questions 18

19. Internal Rate of Return (IRR) This is a technique that equates the PV of the cash out flow with the PV of the cash in flow. The IRR of a project or investment is the discount rate that results in an NPV of zero. 19

20. Internal Rate of Return (IRR) 20 Where: A is the (lower) rate of return with a positive NPV B is the (higher) rate of return with a negative NPV P is the value of the positive NPV N is the absolute value of the negative NPV

21. Practice Questions 21

22. Advantages The main advantage is that the information it provides is more easily understood by managers, especially non- financial managers. A discount rate does not have to be specified before the IRR can be calculated. A hurdle discount rate is simply required which is then compared with the IRR. 22

23. Disadvantages If managers were given information about both ARR and IRR, it might be easy to get their relative meaning and significance mixed up. It ignores the relative size of investments. 23

24. 24 Exercise 1 Evaluate the 3 Projects using PBP, ARR and NPV and offer appropriate advice.