1. Investment Appraisal - Is it worth it?
Risk v. Return
Capital expenditure when deciding whether to:
Produce new product/s
Grow
Reduce costs
Increase productivity
Large expenditure e.g. advertising campaigns

2. Should we invest? The key questions…
What is the total profit the investment will earn?
How long will it take for the investment to recover its original cost?

3. Quantitative Methods of Appraisal
Payback
Average Rate of Return (ARR)
Discounted Cash Flow (NPV)
Internal Rate of Return (IRR)
Usually more than one method is used to reach a decision

4. But first you must estimate expected cash flow of investment…
Year
Cash In
Cash Out
Net Cash Flow
Cumulative Cash Flow
£50,000 1
£30,000
£20,000 2 3
£40,000 4
£10,000

5. Forecasted cash flows Risky business… Predictions for future years
– the future is uncertain!
Who made the predictions?
- independent, trustworthy experts
Quality of information
- large sample size, variables considered
How risky are the figures?
- confidence levels: 100% v 95%

6. Payback
The time it takes for the earnings from an investment to repay the initial cost
Example
Year Cash Outflow Cash Inflow (1) Cash Inflow (2)
1 £500,000 £100,000 £100,000
2 £200,000 £100,000
3 £200,000 £200,000
4 £150,000 £300,000
1.Payback by end of Year 3.
2.Payback: Number of full years + (amount of investment
not recovered/ revenue generated next year) = 31/3 Years

7. Longer the payback, the greater the risk
Payback therefore indicates level of risk associated with the investment
Often used as a screening – rarely used alone

8. ARR
Compares average annual profit generated by an investment with the amount of money invested in it
Average Annual Return x 100
Initial Outlay
Income from investment – Cost of investment = Total profit from
investment
Total profit from investment / Expected lifespan of asset (years)
= Average Annual profit
Average Annual Profit / Cost of investment x 100% = ARR

9. Technique considers the time value of money
Discounted Cash Flows
Technique considers the time value of money
i.e. having money in the hand now is worth more than having the
same quantity of money in the future
Why?
Risk – future cash flows are subject to risk
Opportunity costs – money received now could be used profitably
The longer the delay before money is received, the lower its value
in present-day terms

10. Discounting: What will the money we receive in the future really be worth in today’s terms?
To discount a future cash flow to find its present value
you must:
Know how many years ahead we are looking and what the prevailing interest rate will be
Find the relevant discount factor from the discount tables
Multiply future cash flows by appropriate discount factor to get the present value
The higher the rate of interest expected and the longer you have to wait for the money, the LESS it is worth in today’s terms

11. Net Present Value
Calculates present values of all money coming in from
project in the future and compares it to money being spent
on the project today
Comparisons can be made with other projects to decide which has the highest return in real terms or if any is worth starting
Projects should only be carried out if the NPV is positive
NB Two projects may have the same initial cost,
earn the same inflows, over the same period of time
BUT it is the pattern of the inflows that is crucial,
therefore the NPV of each project will differ

12. Example: Projects X and Y
Project X
Project Y
Year
CF £
DFactor
P Value £
(250,000)
1.00 1
50,000
0.91
200,000 2
100,000
0.83 3
0.75
NPV

13. A comparison Advantages Disadvantages Payback Easy to calculate
Focus on ST
Looks at timing of CF
Does not measure profitability
Ignores time beyond payback
Short-termist
ARR
Uses all CF over life of project
Focus on profitability
Easy comparisons
Not as accurate as payback
Ignores timing of CF
Ignores opportunity cost of money invested
NPV
Looks at opportunity cost of money
Takes amount and timing of cash flows into account
Can consider different scenarios
Choosing correct discount rate can be difficult
Complex to calculate
Often misunderstood

14. Internal Rate of Return (IRR)
Def: the discount rate that when applied to a project produces a NPV of ZERO
It is the maximum rate of interest that one could afford to pay on funds raised to finance a project without making a loss
Accept the project IF:
its IRR ≥ the discount rate that would be used in NPV calculations
This method has the same advantages and disadvantages as NPV

15. IRR continued Method Choose 2 discount rates
Work out the NPV at each rate
Use the following equation to work out the IRR
IRR (%) = A NA__ x (B-A)
NA – NB
A = lower rate percentage
B = higher rate percentage
NA = NPV at rate A
NB = NPV at rate B

16. IRR example Example 1 A = 16% NPV for discount factor A = £4502
B = 18% NPV for discount factor B = (£2698)
What is the IRR?
Example 2
A = 20% NPV for discount factor A = £32559
B = 45% NPV for discount factor B = (£3848)
Example 3
A = 10% NPV for discount factor A = £28652
B = 14% NPV for discount factor B = (£12100)

17. Limitations of quantitative methods:
Assume all costs and revenues can be easily and accurately forecast for future years
Assume that key variables will not change e.g. interest rates
Assume the corporate objective is always to maximise profit

18. What else should be considered?
Qualitative Factors
Corporate Objectives
Corporate Image
External Costs and Benefits
Industrial Relations
State of economy
Past experience