1. Investment Appraisal

2. Investment Appraisal
A means of assessing whether an investment project is worthwhile or not
Can help decide which investment opportunity is better for the firm
Quantitive & Qualititive techniques
Investment project could be the purchase of a new PC for a small firm, a new piece of equipment in a manufacturing plant, a whole new factory, etc
Used in both public and private sector

3. What Capital Investments could we be talking about?

4. Hinges on 3 main factors Firms objectives Opportunities it faces
Constraints it works within

5. Investment Appraisal

6. Investment Appraisal Why do companies invest?
Importance of remembering investment as the purchase of productive capacity NOT buying stocks and shares or investing in a bank!
Buy equipment/machinery or build new plant to:
Increase capacity (amount that can be produced) which means:
Demand can be met and this generates sales revenue
Increased efficiency and productivity

7. Investment Appraisal
Investment therefore assumes that the investment will yield future income streams
Investment appraisal is all about assessing these income streams against the cost of the investment
Not a precise science!
A fork lift may be an important item but what does it contribute to overall sales? How long and how much work would it have to do to repay its initial cost?
Copyright: Loisjune, stock.xchng

8. Payback Period

9. Payback Method
The length of time taken to repay the initial capital cost
Requires information on the revenue the investment generates
Assumes revenue will be evenly distributed across the year / month*
Simple calculation
Indicates level of risk – longer the payback the more risky (unexpected events?)
Fails to take into account profitability – ignores cash flow after payback
Often used purely as a screening process for ideas
* Not always the case e.g. Xmas sales

10. Payback Method example
Cost of machine = £600,000 A
Income
Year 1
245,000
Year 2
265,000
Year 3
320,000
Year 4
400,000
Just by looking at the numbers have we paid back the investment in year 1? B
By year 2?
By year 3?
But in which month?
2.28 years C
2 years plus 600 – (510,000)
320,000
No of yrs before payback + (initial investment A – contribution to date B)
Income in the next year C

11. Payback advantages & disadvantages1 2 3
Page 186 Marcouse

12. Philip Allan Page 144
Exercise 1a

13. Average Rate of Return

14. Average Rate of Return (ARR)
Compares average annual profit generated by the investment with the money invested in it.
Potential projects can be compared
Takes into account all the cash flow throughout the whole life of the project.
Focuses on key factor : PROFIT
BUT ignores cash flow!

15. Average Rate of Return
Step 1 – calculate total profit over the life time of investment
(net cash inflow – investment outlay)
Step 2 – Divide profit by the years the investment will last for
Average annual return or annual profit
ARR =
Initial cost of investment
X 100

16. ARR Example
Year
Net cash flow
Cumulative Cash flow
(20,000) 1
5,000 2
11,000 3
10,000 4
HH Cakes Ltd is thinking of investing $20,000 in a new oven.
Company policy – only invest in projects that deliver over 15% a year
Should I invest in this equipment?

17. Which would you invest in?
Year
Investment A
Investment B
(10,000) 1
10,000
3,000 2
6,000 3
ARR
30%
Cash-flow must be taken into account – not just ARR.

18. Philip Allan Page 144
Exercise 1b, 2 and 3

19. ARR advantages & disadvantages1 2 3
Page 187 Marcouse

20. Investment Appraisal £ now £ in 5 years time Which is worth more?
To make a more informed decision, more sophisticated techniques need to be used.
Importance of time-value of money

21. Cash Flows

22. Discounted Cash Flow Money won’t be worth what it is now in the future
Would you like $100 now or in 5years?
Why?
Future cash flows are at risk
Opportunity cost – what could you do with the money now?
We need to know:
How many years ahead we’re looking
What the prevailing rate of interest will be

23. Discount Factors
Using a formula – DISCOUNT FACTOR tables are created for your use (see page 188 Marcouse)
Higher the rate if interest, and the longer the time before you receive the money = less your money is worth in today’s term!
Can base interest rate on:
Current rate
Expected rate in years to come
Own firms criteria e.g. wants all investments to generate at least 15%
Used in NPV & IRR

24. Discount Factor = -----------------1
Discount Factor =
(1 + i)n
Where i = interest rate
n = number of years
The PV of 10% in 1 years time is
If you invested p today and the interest rate was 10% you would have £1 in a year’s time
Process referred to as:
‘Discounting Cash Flow’

25. Net Present Value (NPV)

26. Net Present Value (NPV)
Takes into account the fact that money values change with time
How much would you need to invest today to earn x amount in x years time?
Value of money is affected by interest rates
Pays close attention to the timing of the cash inflows & relates to the value of money today.
Shows you what your investment would have earned in an alternative investment regime
Allows comparison in REAL terms
Only worth investing if the NPV is positive
Not always easy to compare if initial investment values differ

27. NPV example 52,500 28,500 At 10% interest Year Cash Flow (A)
Discount factor
Present Value (A)
Cash Flow
(B)
Present Value (B)
(250,000)
1.00 1
50,000
0.91
45,000
200,000 2
100,000
0.83 3
0.75
NPV
(250,000)
182,000
83,000
37,500
83,000
150,000
28,500
52,500

28. Net Present Value The principle:
How much would you have to invest now to earn £100 in one year’s time if the interest rate was 5%?
The amount invested would need to be: £95.24
Allows comparison of an investment by valuing cash payments on the project and cash receipts expected to be earned over the lifetime of the investment at the same point in time, i.e the present.

29. Discounted Cash Flow – System A
Year
Cash Flow (£)
Discount Factor (4.75%)
Present Value (£)
(CF x DF)
- 600,000
1.00
-600,000 1
+75,000
71,599.04 2
+100,000
91,136.41 3
+150,000
130,505.61 4
+200,000
166,116.92 5
+210,000
166,513.39 6
113,544.75
Total
285,000
NPV =139,416
Add all the values to get NPV

30. Discounted Cash Flow – System B
Year
Cash Flow (£)
Discount Factor (4.75%)
Present Value (£)
(CF x DF)
- 600,000
1.00
-600,000 1
+25,000
23,866.35 2
+75,000
68,352.31 3
+85,000
73,953.18 4
+100,000
83,058.46 5
+150,000
118,938.10 6
+450,000
340,634.30
Total
285,000
NPV =108,802.70

31. Net Present Value (NPV)
Which System represents the better investment?
System A – why?
System B yields the same return after six years but the returns of System A occur faster and are worth more to the firm than returns occurring in future years even though those returns are greater

32. NPV advantages & disadvantages1 2 3
Page 189 Marcouse

33. Philip Allan Page 148
Exercise 1, 2 and 3

34. Internal Rate of Return (IRR)

35. Internal Rate of Return
The IRR is the rate of interest (or discount rate) that makes the net present value = to zero
Helps measure the worth of an investment
Allows the firm to assess whether an investment in the machine, etc. would yield a better return based on internal standards of return
Allows comparison of projects with different initial outlays
Trial the cash flows with different discount rates
Software or simple graphing allows the IRR to be found

36. IRR equation IRR calculation.xls Yr Cash Flow -100 1 +30 2 +35 3 +40 4
-100 1
+30 2
+35 3
+40 4
+45
(i = interest rate in percent) Internal Rate of Return (IRR) where IRR = i, IRR = 17.09%
Net Present Value (NPV) Thus using IRR = i = 17.09%,
IRR calculation.xls

37. Excel – the way forward!
Very difficult to calculate the IRR manually as trial and error used (could take hours!)
Use Excel = very easy!
Assume the cash flows (from year 0 to year 5) is in the range “D3:J3”, use the formula =IRR(D$3:J$3)

38. Plot two points then draw the curve
IRR
Plot two points then draw the curve

39. Activity IRR exercise.xls

40. IRR

41. Internal Rate of Return
Looking at returns relative to discount rates
NPV
30,000
20,000
10,000
-10,000
-20,000
-30,000 %
Discount
Factor

42. Profitability Index

43. Profitability Index
Allows a comparison of the costs and benefits of different projects to be assessed and thus allow decision making to be carried out
Net Present Value
Profitability Index =
Initial Capital Cost

44. Key considerations for firms in considering use:
Investment Appraisal
Key considerations for firms in considering use:
Ease of use/degree of simplicity required
Degree of accuracy required
Extent to which future cash flows can be measured accurately
Extent to which future interest rate movements can be factored in and predicted
Necessity of factoring in effects of inflation

45. Qualitative Issues Firms Objectives External costs & Benefits
Expected state of the economy
Past experience

46. Philip Allan Page 153
Exercise 1b, 2 and 3