1. Investment Appraisal

2. Investment appraisal This refers to a series of analytical techniques designed to answer the question - should we go ahead with a proposed investment? There are four techniques and all involve a comparison of the cost of the investment project with the expected return in the future

3. The four techniques PaybackThe time taken to recover the cost of the investment Accounting rate of return Profits earned on investment expressed as a % of the cost of the investment Net present value The present value of net cash flows received in the future less the initial cost of the investment Internal rate of return The discount rate that causes the net present value of an investment to be zero

4. The non-discounting methods The first two methods are non- discounting methods The financial return from an investment comes in a stream over a number of years The non-discounting methods make no distinction between the return which comes in in ten years time from the return that will come during the current year In other words these methods ignore the time of money

5. Payback A simple method of investment appraisal It focuses on the length of time needed to recover the capital costs of an investment The payback period is the number of years it takes the cash inflows from a capital project to equal the cash outflows A firm may have a target payback period, above which projects are reject It is usually expressed in terms of years or months It is calculated by adding up the annual returns from an investment until the cumulative total equals the initial cost

6. Decisions based on payback Accept the project if the payback period is less than the target period Reject the project if the payback period is more than the target period In the case of competing investment projects, rank projects by payback and accept the project with the shortest payback period (provided it meets the target payback period)

7. The discounting methods The significant feature of these methods is that they take into account the time value of money What this means is that we recognise money received in the future does not have the same value as money received today The test of this proposition is simple: which do you prefer £1000 in your hand today of the promise of £1000 in five years time ?

8. Discounting We discount the value of the return received in the future because of the inconvenience of having to wait Money promised in the future is worth less than the same money received today Discounted cash flow involves discounting (reducing) the future expected cash inflows and outflows of a potential project back to their present value today

9. Present value Present value places a value for today on earnings to be received at some future date It is the cash equivalent now of a sum receivable or payable at a future date The basic principle of discounting is that if we wish to have £x in a years time we need to invest a certain sum less than £x now at the interest rate of r% in order the required sum of money in the future In effect, it is compound interest in reverse

10. The superiority of the discounting methods NPV and IRR take into account: –profits over the whole life of the project –the timing of the return But –may be difficult to apply –lacks consideration of short term liquidity

11. Net present value NPV is a technique which discounts future expected cash flows to today’s monetary values using an appropriate cost of capital This compares the initial cost of the project with the future discounted cash flows it generates NPV = the discounted cash inflow minus the initial cost of the investment If NPV is positive, the project will be considered profitable and worthwhile If it is negative, it will be considered unprofitable and will be rejected

12. Notes to the example Year zero refers to now - the year zero figure refers to cost of equipment it is shown as negative cash flow The present value is the value of money received in the future. It is calculated by multiplying the cash inflow for the year by the appropriate discount factor Add up the present values in the final column not forgetting to deduct the negative figure for year zero

13. General rules Positive NPVThe project is accepted - the return exceeds the required rate of return Zero NPVThe project is acceptable - the return equals the required rate of return Negative NPV The project is rejected - the return is less than the required rate of return

14. Advantages of NPV It recognises the whole life of a project It takes into account net cash flow and outflows for the duration of the project It takes into account the time value of money i.e. money in the future is worth less than the same amount of money received today It makes allowance for the opportunity cost involved in investing

15. Disadvantages of NPV Involves complex calculations Easily misunderstood Not useful for preliminary screening of investment projects Difficult to choose a discount rate- especially for a long term project Often based on an arbitrary rate of discount Results are highly sensitive to assumptions such as discount rate and planning horizon

16. Internal rate of return The true interest rate earned by the investment over the course of its economic life This is defined as the annual % return achieved by a project at which the sum of the discounted cash inflows over the life of the project is equal to the of the discounted cash outflows The rate of discount at which discounted cash inflow equals the cost of the equipment The rate of discount where NPV = Zero Whereas NPV is expressed as a sum of money, IRR is the expected yield in % terms

17. Internal rate of return Identify the rate of discount at which the discounted cash inflow equals the cost of the project At this point the NPV will be zero The ascertaining of the IRR enables decision makers to compare IRR with the required rate of return on investment laid down by top managers

18. Decision rule Go ahead with the proposed investment if the IRR exceeds the rate of interest on borrowed money Where there is a choice of projects, choose the one with the highest IRR