1. INVESTMENT APPRAISAL

2. INVESTMENT
Refers to the purchasing of capital goods such as equipment, vehicles and new buildings; and improving fixed assets

3. INVESTMENT APPRAISAL
Evaluating the profitability or desirability of an investment project. It assesses the economic viability of potential investment options so as to arrive at the most acceptable alternative depending on the criteria used for comparing these projects

4. INVESTMENT APPRAISAL TECHNIQUES
Payback Period - Uses Cash Flows
Average Accounting Rate of Return (ARR / AARR)- Uses Net Profit
Net Present Value (NPV) - Uses Cash Flows
Internal Rate of Return (IRR) - Uses Cash Flows

5. PAYBACK PERIOD
This is the length of time necessary to recover the entire cost of an investment from the resulting annual net cash flows. Payback Period = (Number of years before recovery of initial investment) + ([Amount of investment remaining to be recaptured / Total cash flow during year of payback] x 12)

6. EXAMPLE
The following refers to information relating to the investment in two projects:
YEAR
PROJECT A
PROJECT B
0 (Initial Investment)
($500,000) 1
$300,000
$10,000 2
$200,000
$20,000 3
$50,000 4
$135,000 5
$5,000

7. CALCULATING PAYBACK PERIOD
Calculate cumulative cash flow
YEAR
PROJECT A
PROJECT A CUMULATIVE CASH FLOW
PROJECT B
PROJECT B CUMULATIVE CASH FLOW
($500,000) 1
$300,000
($200,000)
$10,000
($490,000) 2
$200,000 $0
$20,000
($470,000) 3
$50,000
($270,000) 4
$60,000
$135,000
($135,000) 5
$5,000
$65,000

8. CALCULATING PAYBACK PERIOD cont’d
Payback will occur where the cumulative cash flow is equal to zero (0).
Project A – Payback period is 2 years. (Straightforward)
Project B – Payback Period = 4yrs and ? (To Calculate)
? = (Amount of investment remaining to be recaptured / Total cash flow during year of payback) x 12
= ($135,000/ $200,000) x 12
= 8.1 months
Final Answer is 4yrs and 8.1mths

9. ADVANTAGES OF PAYBACK METHOD
It is easy to calculate and understand
It focuses on risk and therefore promotes prudence and caution
By focusing on liquidity (cash flow) rather than profitability, this method is looked upon favorably by lenders of capital

10. DISADVANTAGES OF PAYBACK METHOD
It fails to take into account cash flows after the payback period
It does not take into consideration the time value of money
It only looks at cash flows and does not consider overall profitability

11. Average Accounting Rate of Return (AARR / ARR)
Unlike other appraisal methods, the ARR uses profit instead of cash flows. This method therefore give profitability of the investment as a percentage of the initial investment. The usual difference in a question between cash flow and profitability is depreciation. In order to arrive at profit when given cash flows, you need to minus depreciation per year from the cash flows.

12. AARR / ARR EQUATION
ARR = (Average Annual Profit /Initial Investment) x 100

13. CALCULATING ARR /AARR
Calculate profit if depreciation per year is $10,000 for Project A and $15,000 Project B
YEAR
CASH FLOW PROJECT A
PROFIT PROJECT A
CASH FLOW PROJECT B
PROFIT PROJECT B
($500,000) 1
$300,000
$290,000
$10,000
($5,000) 2
$200,000
$190,000
$20,000
$5,000 3
$50,000
$40,000
$185,000 4 $0
$135,000
$120,000 5
Total
$515,000
$490,000

14. CALCULATING ARR /AARR cont’d
Project A = [($515,000/5) / $500,000] x 100
= ($103,000 / $500,000) x 100
= 20.6%
Project B = [($490,000/5) / $500,000] x 100
= ($98,000 / $500,000) x 100
= 19.6%

15. ADVANTAGES OF AARR / ARR
It focuses on profitability in all years unlike payback
It focuses on profitability, which is the central objective of many business decisions
The result is easy to understand and compare with other projects

16. DISADVANTAGES OF AARR / ARR
It ignores the timing of profit flows. This could result in two projects having the same ARR but with different paybacks
The time value of money is ignored

17. NET PRESENT VALUE (NPV)
This method takes into consideration the fact that future cash flows will lose value over time. This method therefore discounts all future cash flows and brings them to present values. (Using a Present Value Interest Factor [PVIF] table) This summed total of all of the Present Values is then subtracted from the initial investment in order to calculate the Net Present Value. The project with the highest positive NPV would be chosen.

18. CALCULATING NPV PROJECT A YEAR CASH FLOW 10% DISCOUNT FACTOR
PRESENT VALUE
($500,000) 1
$300,000
0.9091
$272,730 2
$200,000
0.8264
$165,280 3
$50,000
0.7513
$37,565 4
$10,000
0.6830
$6,830 5
$5,000
0.6209
$3,104.50
NPV
($14,490.50)

19. CALCULATING NPV PROJECT B YEAR CASH FLOW 10% DISCOUNT FACTOR
PRESENT VALUE
($500,000) 1
$10,000
0.9091
$9,091 2
$20,000
0.8264
$16,528 3
$200,000
0.7513
$150,260 4
$135,000
0.6830
$92,205 5
0.6209
$124,180
NPV
($107,736)

20. ADVANTAGES OF NPV It takes into account the time value of money
It considers the cash flows for the entire project

21. DISADVANTAGES OF NPV It is more complicated to calculate
The discount rate is only an estimate, this could change at any moment

22. INTERNAL RATE OF RETURN (IRR)
Attempts to find the discount rate where NPV is equal to zero.(ie. When the cost or initial investment = discounted cash flows). This rate is then compared to the interest rate which is charged when borrowing to invest (Cost of Capital)If that rate is more than the cost of capital then the project should be profitable. The IRR is therefore the rate at which the company internally generates profit on its investment. (Not required to work it out for exams)