Investment Appraisal Techniques and Methods

Payback Period

The time it takes for the project to pay back the initial outlay.

Investment Appraisal

A technique used to evaluate planned investment by a business and measure its potential value to the business.

Average Rate of Return (ARR)

An investment appraisal technique which calculates the average annual profit of an investment project, expressed as a percentage of the sum of money invested.

Month of Payback

Income needed in period divided by Contribution per month.

Discounted Cash Flow (DCF)

An investment appraisal method that considers the time value of money.

Net Present Value (NPV)

The value of future money if you had it now, considering inflation and the potential for earning interest on investment capital.

Cumulative Cash Flow

The total cash flow accumulated over time.

Initial Outlay

The initial amount of money invested in a project.

Advantages of Payback Period

Easy to calculate and simple to use; helps with managing cash flow; considers timings of cash flows.

Disadvantages of Payback Period

Ignores timings of the cash flows; does not allow for effects of inflation on values of future cash flows; ignores what happens after the payback period.

Calculation of ARR

ARR = (Average Annual Return / Initial Outlay) * 100.

Example of Payback Calculation

A £100,000 investment brings in £30,000 in Year 1, £40,000 in Year 2, £60,000 in Year 3, and £35,000 in Year 4.

Contribution for Year 3

The total income, or contribution, for year 3 is £60,000, so the monthly contribution is £5000.

Example of Payback Period Calculation

Using the formula, we get: £30000 / £5000 = 6 months; so, payback period is 2 years and 6 months.

Discount Factor

A factor based on bank interest rates used in NPV calculations.

Lifetime Profit Calculation

Identify lifetime profit of £16,000 and divide by number of years (4) to get £4,000.

Advantages of DCF

Allows for future earnings to be adjusted to present values; easy to compare different projects.

Disadvantages of DCF

May encourage a short-term attitude; ignores total profitability, focusing just on the speed to which the initial outlay is repaid.

Cash In

The total cash inflow from an investment in a given period.

Cash Out

The total cash outflow from an investment in a given period.

Net Cash Flow

The difference between cash inflow and cash outflow in a given period.

Example of Cash Flow

Year 0: Cash In = £0, Cash Out = £50,000, Net Cash Flow = (£50,000).

Cumulative Cash Flow Example

Year 4: Cash In = £40,000, Cash Out = £10,000, Net Cash Flow = £30,000, Cumulative Cash Flow = £30,000.

Present Value

The value of future cash flows discounted to reflect their worth today.

Discount Factor

A multiplier used to calculate the present value of future cash flows, which decreases as time increases.

Net Present Value (NPV)

The difference between the present value of cash inflows and outflows over a period of time.

Inflation Impact

The effect of rising prices on the value of future cash flows.

Risk Effect

The influence of uncertainty on the estimated future cash flows.

Qualitative Factors

Non-numeric considerations that affect investment decisions, such as staff impact and ethical considerations.

Investment Objective

The strategic goals a business aims to achieve through investment.

Economic Climate

The overall state of the economy, which can influence investment decisions.

Cash Flow

The total amount of money being transferred into and out of a business.

Interest Rate Estimation

The prediction of future interest rates, which can affect the accuracy of discount factors.

Ethical Considerations

Factors related to the moral implications of an investment, such as environmental impact.

Funding Availability

The accessibility of financial resources required to support an investment.

Technology Availability

The presence of new technology that can encourage further investment.

Managerial Confidence

The level of optimism among managers regarding investment decisions.

Investment Types

Capital goods investments (e.g., machinery) and research and development investments.

Autonomous Investment

Investment made for the replacement of worn-out goods.

Induced Investment

New investment that arises from expansion efforts.

Payback Period

The time it takes for an investment to generate enough cash flow to recover its initial cost.

Discounting Future Cash Flows

The process of determining the present value of future cash flows by applying discount factors.

Investment Appraisal

The evaluation of the potential profitability of an investment.

Cash Flow Calculation

The method of determining the cash inflows and outflows associated with an investment.

NPV Calculation Formula

NPV = Cash inflows - Cash outflows.

NPV Percentage Calculation

NPV / Initial Investment * 100.

Future Cash Flow Example

Cash flows projected for investment options, such as Project Z and Project Y.

Investment

Large amounts of money are often invested in the hope that this will give a profitable return on the investment.

Risk with Investment

There is no certainty that the investment will result in increased profits and could even result in a reduction of future revenue.

Investment Appraisal Methods

Different methods used to compare projects that may be competing for a business's investment capital.

Example of Payback Period

If a project costs £20,000 and the net cash flows generated by the project are £10,000 each year, the payback period is 2 years.

Investment Objectives

Businesses will often invest money to meet objectives such as sales growth, increase profitability, expansion to new markets, relocation, or training its existing workforce.

Capital Goods

Goods used in the direct or indirect production of other goods e.g. lorries, computers, new machinery, and buildings.

Research and Development Investment

Investment in research and development and aspects in human resource management such as financial motivational methods and quality improvement programmes.

Autonomous Investment

Investment made for the replacement of worn out goods.

Induced Investment

New investment arising from expansion.

Technology-Driven Investment

Investment that arises from the availability of new technology.

Net Cash Flows (NCFs)

The expected cash inflows generated by a project over time.

Comparison of Investment Options

When there are different investment options, the payback period method selects the one that returns the initial cost of the investment in the shortest time frame.

Worked Example of Payback Method

A business comparing two capital investment projects: Option 1 costs £90,000 and Option 2 costs £110,000 with varying NCFs over 5 years.

Option 1 NCF

Costs £90,000 with expected cash flows of £20,000, £30,000, £40,000, £20,000, and £20,000 over 5 years.

Option 2 NCF

Costs £110,000 with expected cash flows of £10,000, £20,000, £40,000, £60,000, and £50,000 over 5 years.

Payback Period

The time it takes for an investment to generate an amount of cash flow equal to the initial cost of the investment.

Cumulative Cash Flow

The total cash flow accumulated over time, which is used to determine the payback period.

Option 1 Cost

The initial investment amount for Option 1, which is £90,000.

Option 2 Cost

The initial investment amount for Option 2, which is £110,000.

Monthly Cash Flow

The cash flow generated per month during the final year of the investment, calculated by dividing the annual cash flow by 12.

Payback Period for Option 1

3 years.

Payback Period for Option 2

3 years and 8 months.

Balance of Initial Investment

The remaining amount of the initial investment that needs to be paid back during the final year.

Average Rate of Return (ARR)

A method that measures the average net return every year relative to the cost of the investment, expressed as a percentage.

Total Cumulative Cash Flow for Option 1

£130,000.

Total Cumulative Cash Flow for Option 2

£180,000.

Average Profit per Annum for Option 1

£8,000.

Average Profit per Annum for Option 2

£14,000.

Initial Cost of Investment for Option 1

£90,000.

Initial Cost of Investment for Option 2

£110,000.

Net Cash Flow for Option 1

The total cash flow after subtracting the initial investment, which is £40,000.

Net Cash Flow for Option 2

The total cash flow after subtracting the initial investment, which is £70,000.

Calculation of ARR

Divide the average net cash flow per annum by the initial cost of the project, and multiply by 100.

Effective Use of Payback Period

Particularly useful for investments in fast-changing technologies to recover costs quickly.

Advantage of Payback Period

Simple to use and easy to calculate.

Disadvantage of Payback Period

Ignores cash flows over the lifetime of the project and total profitability.

Final Year Cash Flow for Option 2

£60,000.

Months to Payback Remaining Balance

8 months.

Total Payback Time for Option 2

3 years 8 months.

Average Profit per Annum

The profit generated by an investment over a year, used to calculate the ARR.

ARR

Average Rate of Return, calculated as Average profit per annum x 100 / Initial investment cost.

Option 1 ARR

8.8%, calculated as £8,000 x 100 / £90,000.

Option 2 ARR

12.72%, calculated as £14,000 x 100 / £110,000.

Interest Rate Comparison

ARR can be compared with bank interest rates to determine the better investment option.

Advantages of ARR

Shows the profitability of the option/project, includes all the project's cash flows, easy to compare different projects.

Disadvantages of ARR

Ignores the timing of the cash flow, does not allow for effects of inflation on future cash flows.

Discounted Cash Flow (DCF)

A method of investment appraisal that considers the time value of money.

Net Present Value (NPV)

The value of future money if you had it now, accounting for inflation and potential interest earnings.

Cumulative Cash Flow

The total cash flow accumulated over the years for an investment option.

Discount Factor

A value used to determine how much future cash flows are worth today, based on interest rates.

Discount Factor for Year 1

.952 at a discount rate of 5%.

Discount Factor for Year 2

.907 at a discount rate of 5%.

Discount Factor for Year 3

.864 at a discount rate of 5%.