1. Investment Appraisal

2. Homework Plan an activity on investment appraisal for the class.
Plan a 10 minute lesson which makes use of the activity.
You should include: definitions/formula/explanations on how to carry out the method/the advantages and disadvantages of the method/why qualitative data should be used in partnership with investment appraisal.

3. What is investment appraisal?
Investment Appraisal is the use of scientific decision-making tools to analyse whether a proposed future investment should go ahead.
There are 3 techniques that all involve a comparison of the cost of investment project with the expected return in the future.

4. The three techniques Payback
The time taken to recover the initial cost of the investment.
Average Rate of Return (ARR)
The profits earned on investment expressed as a % of the cost of initial investment.
Net Present Value (NPV)
The total returns from an investment in today’s terms.

5. Learning objectives
Define, apply and critique two methods of investment appraisal:
Payback
Average Rate of Return

6. Payback
Payback measures the time it will take to payback the initial cost of the investment.
This includes calculating the year and month in which it will be paid back.
Payback is the most commonly used by businesses due to its simplicity. However, rarely used on its own.

7. Payback Very important to a business with cash flow problems
Also if the business is investing in equipment that may become out-of-date quickly.
May be important if the business is run on external sources of finance.

8. Payback example A company plans to buy a new machine costing £500,000
Year
Cash out
Cash in
Net Cash Flow 1 2 3 4 5
A company plans to buy a new machine costing £500,000
It will bring in new revenues of £100,000 the following year and then £150,000 for each of the following four years.
There will maintenance costs of
Year 3: £20,000
Year 4: £30,000
Year 5: £50,000
How long will it take to repay the initial investment? 8

9. Payback example A company plans to buy a new machine costing £500,000
Year
Cash out
Cash in
Net Cash Flow
£500,000
(£500,000) 1 £0
£100,000 2
£150,000 3
£20,000
£130,000 4
£30,000
£120,000 5
£50,000
A company plans to buy a new machine costing £500,000
It will bring in new revenues of £100,000 the following year and then £150,000 for each of the next four years.
There will maintenance costs of
Year 3: £20,000
Year 4: £30,000
Year 5: £50,000
How long will it take to repay the initial investment? 9

10. Payback example
Year
Cash out
Cash in
Net Cash Flow
£500,000
(£500,000) 1 £0
£100,000 2
£150,000 3
£20,000
£130,000 4
£30,000
£120,000 5
£50,000
£110,000
We determine the payback period by calculating the cumulative next cash flow until the initial outlay is paid off.
YEAR 1
£100,000
YEAR YEAR 2
£100,000 + £150,000 = £250,000
YEAR YEAR YEAR 3
£100,000 + £150,000 = £130,000 = £380,000
YEAR YEAR YEAR YEAR 4
£100,000 + £150,000 + £130, £120,000 = £500,000
Investment of £500,000 is paid back in year 4 10

11. It’s never that easy!
Most payback problems require you to calculate the specific month of payback as well as the year.
How do we do this?

12. Payback example: Machine A
Year
Cash out
Cash in
Net Cash Flow
£750,000
(£750,000) 1
£7,500
£150,000
£142,500 2
£200,000
£192,500 3
£260,000
£252,500 4 5
£300,000
£292,000
Step 1: Find the year of payback
Add up net cash flows year by year until the cumulative net cash flow exceeds the initial investment
YEAR 1
£142,500
YEAR YEAR 2
£142,500 + £192,500 = £335,000
YEAR YEAR YEAR 3
£142,500 + £192,500 + £252,500 = £587,500
YEAR YEAR YEAR YEAR 4
£142,500 + £192,500 + £252, £252,500 = £840,000
Since the investment of £750,000 is more than the cumulative net cash flow in year 3 but less than in year 4, we know that the investment is paid back sometime in Year 4. On to step 2… 12

13. Payback example: Machine A
Year
Cash out
Cash in
Net Cash Flow
£750,000
(£750,000) 1
£7,500
£150,000
£142,500 2
£200,000
£192,500 3
£260,000
£252,500 4 5
£300,000
£292,000
Step 2: Find the month of payback which the investment is paid back
a) Calculate remaining cash required
£750,000 - £587,500 = £162,500
At end of year 3
b) Divide remaining cash required by net cash flow for that year and multiply by 12
£162,500
£252,500
= x 12 = 7.728
months
c) Round up to next month
d) Add back the number of years
Payback period is 3 years and 8 months 13

14. Payback
The shorter the payback period the less risk there is involved in the project and the quicker the business start to generate profit from the investment.

15. Disadvantages of payback
Doesn’t take into account the business’ profitability.
Doesn’t take into account additional cash inflow after the payback period
Assumes steady inflows throughout the year.
Exam Help:
Try and think of payback in relation to the business, such as expected lifespan of the project, seasonality and cash flow situation. 15

16. Activity Calculate payback period for Machine B
Which is the best investment?

18. Payback example: Machine B
Year
Cash out
Cash in
Net Cash Flow
£310,000
(£310,000) 1
£15,000
£125,000
£110,000 2
£127,000
£112,000 3
£140,000 4 5
£130,000
£115,000
Step 1: Find the year of payback
Add up net cash flows year by year until the cumulative net cash flow exceeds the initial investment
YEAR 1
£110,000
YEAR YEAR 2
£110,000 + £112,000 = £222,000
YEAR YEAR YEAR 3
£110,000 + £112,000 + £125,000 = £347,000
Since the investment of £310,000 is more than the cumulative net cash flow in year 2 but less than in year 3, we know that the investment is paid back sometime in Year 3. On to step 2… 18

19. Payback example: Machine B
Year
Cash out
Cash in
Net Cash Flow
£310,000
(£310,000) 1
£15,000
£125,000
£110,000 2
£127,000
£112,000 3
£140,000 4 5
£130,000
£115,000
a) Calculate remaining cash required
£310,000 - £222,000 = £88,000
At end of year 2
b) Divide remaining cash required by net cash flow for that year and multiply by 12
£ 88,000
£125,000
= x 12 =8.448
months
c) Round up to next month
d) Add back the number of years
Payback period is 2 years and 9 months 19

20. Learning objectives
Define, apply and critique the Average Rate of Return as a method of investment appraisal:

21. Average Rate of Return (ARR)
Assesses the value of an investment by calculating the average annual profit as a percentage of the initial investment cost.
Therefore the formula is…

22. ARR formula x 100 = Average annual profit Initial investment
Number of years*
Total net cash flow
Average annual profit =
* The “life” of the asset

23. ARR example: Machine A Step 1: Calculate average annual net profit
Year
Cash out
Cash in
Net Cash Flow
£750,000
(£750,000) 1
£7,500
£150,000
£142,500 2
£200,000
£192,500 3
£260,000
£252,500 4 5
£300,000
£292,500
Step 1: Calculate average annual net profit
Total net cash flow
Life of the asset
£382,500 5 =
= £76,500
Step 2: Divide average annual profit by the initial investment and multiply by 100
£76,500
£750,000
X 100
= 10.2%
£382,500 23

24. ARR The higher the ARR the potentially profitable the investment.
Allows easy comparison to other forms of investment like bank interest rates.
It can be easily compared to the current or target ROCE.

25. Disadvantage of ARR
Doesn’t take timing of the cash flow into account

26. Activity Calculate ARR period for Machine B
Which is the best investment?

28. ARR for Machine B Step 1: Calculate average annual net profit
Year
Cash out
Cash in
Net Cash Flow
£310,000
(£310,000) 1
£15,000
£125,000
£110,000 2
£127,000
£112,000 3
£140,000 4 5
£130,000
£115,000
Step 1: Calculate average annual net profit
Total net cash flow
Life of the asset
£277,000 5 =
= £55,400
Step 2: Divide average annual profit by the initial investment and multiply by 100
£55,400
£310,000
X 100
= 17.9% 28

29. Conclusion
Machine A
Machine B

30. Learning objectives
Define, apply and critique two methods of investment appraisal:
Payback
Average Rate of Return

31. Confidence levels
Payback
Are you Cowell or Cole?
ARR 5 5

34. Learning objectives
Define, apply and critique two methods of investment appraisal:
Payback
Average Rate of Return

35. Net Present Value (NPV)
Takes into account the total return from an investment in today’s terms.
This is done using the
DISCOUNT FACTOR
The rate by which future cash flows are reduced to reflect the current interest rates.

36. NPV An another advantage of NPV is that is takes into account the
This is the recognition of the fact that £1 today is worth more than £1 in the future.
time value of money

37. Time value of money
Suppose I have £10 today and I put that money in the bank for two years at an interest rate 10%. How much will I end up with in 2012?
£10 x 10% x 10% = £12.10
Or more accurately,
£10 x 1.1 x 1.1 = £12.10
This is compound interest.
A shorter formula for compound interest is (1+0.1)2

38. Discount factor
How would I find out how much £12.10 in two years’ time is worth today?
In effect, it is the reciprocal of the compound interest formula
And is known as the discount factor:
= £12.10 x 1÷ (1+0.1)2 = £10.00
= £12.10 x = £10.00

39. NPV Example: Machine A

40. Calculate NPV for Machine B

41. NPV Example: Machine B 41

42. Conclusion
Machine A
Machine B

43. Net Present Value (NPV)
If POSITIVE value then the project is profitable and is therefore WORTHWHILE
If NEGATIVE value then the project is considered unprofitable and will be REJECTED

44. Advantages of NPV Takes account of whole life of the investment
Takes into account net cash flows for whole period
Takes account of the time value of money
Takes account of the opportunity cost of the project

45. Disadvantages of NPV
Quite complex and technical – not easily understood by non-financial managers
Often inaccurate discount factor over time

46. Confidence on investment appraisal
Payback
Cowell or Cole?
ARR
NPV 5 5 5

48. Risks of investment decisions
Sum to invest
Source of funds
Impact on rest of business
Ability to reverse decision
Impact of investment of future plans

49. Uncertainties of investment decisions
Market stability – extent of change
Competitor reactions
Economic environment
Accuracy of cash flow projections
Projected life of investment decision

50. Qualitative factors Aims and objectives of the business
Image- effect on reputation and brand
Personnel: work habits, morale, culture etc.
Consumer perceptions
Effect on communities
Production issues
Cultural issues