Unit 7.8 - Investment appraisal

Investment

typically associated with the purchase of non-current assets or purchasing part/the whole of other businesses. However, Investment can be any significant expenditure a business outlays with the aim of improving performance.

Investment appraisal

series of techniques designed to assist businesses in judging the desirability of investing in particular projects.

Risk (in investments)

the chance of something adverse or bad happening, in investment appraisal this typically refers to the chance of costs being higher then expected or sales being lower than forecast

What may a business invest in and when

When introducing new products - comparing possible options

Expansion - investing in fixed assets (buildings)

Investing in new technologies - non-current assets. These reduce costs and improve efficiency in the long run

Investing in infrastructure - Very costly, the government would certainly do this (supply-side

Promotional campaigns - Advertising and other promotional methods can be costly

Training employees - May compare this to the cost of capital goods

Brand development - Pushing products into new markets and increasing exposure

Data investment appraisal techniques base their recommendations

- Initial cost of the investment

- The net return (revenue minus costs) per annum

- The lifetime of the investment

The 3 types of investment appraisal and their unit of measurement

Payback - Years and months (want as low as possible

Average rate of return (ARR) - percentage (%) (want as high as possible

Net Present Value (NPV) - Monetary value £ (want as high as possible

Payback (definition)

Measures the time period (years and months) for earnings from an investment to recoup original cost from its net inflows

Average rate of return - ARR (definition)

Total net returns divided by the expected lifetime of the investment (usually a number of years), expressed as a percentage of the initial investment

Net present value - NPV (definition)

Net return on an investment when all revenues and costs have been converted to their current worth

Payback - how to calculate

If number of years is exact

Add the net returns each year from an investment until it equals the initial cost of the investment - the number of year this takes is the payback.

If payback is achieved in between years

Same as above but when you are going to go over the initial investment in the year you must calculate how much more is needed in the following year to achieve payback, then the formula is:

(Amount of inflow needed to achieve investment/inflow generated in the next year) x 12 (for months or x 52 for weeks)

How ARR is calculated (formulas)

Calculate the Average annual profit (AAP)

Total net returns/investment life expectancy

Calculate the ARR

(AAP/cost of investment) x 100

How NPV is calculated

Each year's net return x the discount factors = present values for each year

Add all present values - cost of investment = net present value

Advantages of payback

- Easy to calculate - saves time

- Easy to understand - It is how long it takes to get money back

- Emphasises cash-flow - useful for firms in cash-flow difficulties or with less cash i.e start-ups

- By emphasising speed of return its popular with forms in fast changing markets where future forecasts will be less reliable

Disadvantages of payback

-

- Ignores the time value of money

- Requires an arbitrary cutoff point

- Ignores cash flows beyond the cutoff date so doesn't consider the overall return of the investment

- Biased against long-term projects, such as research and development, and new projects - may encourage shortism

- Difficult to establish a target payback time

Advantages of ARR

- shows profitability of an investment over given period of time

- unlike payback period, it uses all the cash flows in a business, therefore showing true profitability

- easy comparisons with other projects, therefore opportunity cost is easy to see

- Understood by non-accountants

disadvantages of ARR

- likely to be forecasting errors as long term

- does not consider timing of cash inflows

- effects of time value of money are not considered

- Slightly more difficult to calculate than payback so may use up more time

Advantages of NPV

- considers time value of money and opportunity cost

- considers cash flows

- absolute measure that can be used to maximize shareholder's wealth

- As sums into the future are discounted more heavily, reduces importance of long term estimates being possibly inaccurate

- Precise answer - if NPV is positive the investment should be undertaken if negative should be rejected

Disadvantages of NPV

- more complicated and time consuming the other methods

- More difficult to understand making some decision making distrustful of results

- Based on choice of discount factors which could be inaccurate

Investment criteria

The ways in which a business will judge whether an investment should be undertaken.

Investment criterias influences on investment decisions

Businesses will compare the results of the investment appraisal and the over investment against investment criteria such as:

- Strategic fit: Consistent with corporate strategy

- Cash-flow implications: not cause short term liquidity issues

- Prestige: enhance reputation, image, brand

- Market conditions: Expected to grow or decline

- Competition

- Change: PESTLE factors

- Impact on stakeholders

- Strengths: does it enhance or play into strengths of business

Non-financial (qualitative) influences on investment decision

Some may include:

- Aims of organisation

- Reliability of data

- Workforce

- The economy

- Legal recruitments

- Subjective criteria: i.e managers intuition or attitudes

Risk and uncertainty

The probability of unforeseen circumstances that may harm the success of a business decision

Risk and uncertainty influences on investment decisions

Costs may be higher than forecast

Sales (revenue) may be lower than forecast

due to:

Timescales: Further into the future makes forecasts less accurate.

New markets: If an investment involves entering new markets they have no experience or previous financial record to help forecast

Competitors reaction: Rival can react through similar investments, advertising, cutting prices bringing new products to market

Unique project: No previous experience or data

How businesses take into account risk and uncertainty in investments

- Building allowances for fluctuation in sales revenue and costs:

- Purchase raw material on the forward market:

- Ensuring the business has sufficient financial assets available:

- Build in contingencies in case of problems

- Use sensitivity analysis to calculate multiple scenarios

- Set more demanding targets i.e short payback, high ARR - therefore allowing for risk and uncertainty

Sensitivity analysis

A technique used to examine the impact of possible changes in certain variables (sales, costs) on the outcome of a project or investment.

Will calculate multiple scenarios, the aim will be to avoid the worst case scenarios and put plans in place to do so