business 3.8

payback period

• Used to work out the number of years/months it takes for the investment of a business to pay for itself

• The business estimates future cash flow each year then determines the month and year in  which the cash flows will finall cover investment cost

calculating payback period

• When total net cash flows (cash inflow - cash outfloww) are equal to initial investment cost, business has reached payback period

• Step 1: calculate net cash flow for each year

  • Year 0 is where initial investment is recorded (cash inflow always 0, so net cash flow is 0 minus investment cost)

• Step 2: calculate cumulative net cash flow

  • Cumulative net flow in precious year + net flow of current year

• Step 3: calculating payback period

  • Look at the year where cumulative cash flow turns positive

  • To know how many months into the year it will take to pay the investment:

    • Payback period = (amount left to pay/net cash flow in that year) x 12

      • Amount left to pay: Add net cash flows from previous 2 years up, and subtract that from total investment 

    • Shortner payback periods bring positive net cash flows more quickly and are less risky 

evaluation of payback period

• Benefit, simplicity: Gives simplistic view and only relies on cash flow forecasts, which are estimates

•  Limit: ignores long term profitability of investment, desirable investment may be overlooked

• Limit: assumes that future cash flows have the same value as those of today, however a business owuld have to account for inflation

• Limit: different businesses will weigh up payback period diffrently in decision making, ex social enterprises may nnot prioritise length of payback period

ARR

• Expresses the annual forecast returns as a percentage of the initial capacity costs

• Return is a nother term for net cash flow

• ARR = (  [ {total returns - capital cost} / years of use ] / capital cost ) x 100

calculating ARR

• Step 1 : calculate net cash flow (returns) over the life time of the investment minus the capital cost 

• Step 2: divide the result by number of years of use 

• Step 3: divide the result by initial cost of investment and multiply the result by 100

interpreting ARR

• Another way of considering investment profitability 

• Business can compare investment options in order to select those with the highest rates of return

• Compares with the interest it might receive from holing it's money in bank account and with all other potential business opportunities

• If another project is predicted to have a higher rate of return, then that project should be given preference

• Risk needs to be taken into account, keeping money in a savings account comes with low risk, but investment comes with greater risk, a business needs to decide if risk is worth it 

net present value

• Money holds less value in the future due to inflation and banks paying lower interest on deposit than inflation rate

• Inflation: increase in the general price level of the economy

• Payback period and ARR fails to consider inflation, NPV shows real value of estimated future net cash flows so that investment appraisal is more accurate

• Present value (single year ) = net cash flow x discount factor 

• NPV = sum of presennt values of return - original cost

discount factor

• Rate that a business could earn on another comparable investment

• When that rate is applied to the expected future cash flows from an investment, these cash flows can be reduce to reflect todays value of future cash flows

• By doing this, a business can compare different investment options, even with different lengths of time for execution

calculating NPV

• Step 1: discount the net cash flows in each year 

• Step 2: find the NPV

evaluation of NPV

• Benefit: considers the change in value of money over time, provides the business with a more accurate understanding of the future value of cash flows from investment

• Benefit: allows the business to compare opportunities with different investment periods

• Limit: more complex to calculate

• Limit: assumption about future value of money may be inaccurate 

evaluation of investment appraisal

• Before making investment decisions, a business must consider

  • Return on investment: how much would they want to obtain

  • Cost savings: would the investment cut costs in other department

  • Break even: would it help ot prevent the business from breaking even

  • Market share:  could this increase or decrease market share

  • Financing: what kind of financing would the business use for the investment

  • Cash flow assumptions; how confident is the business in it's cash flow assumptions

  • Mission statement: does the investment align with the mission statement

• Business can chose to spend their retained profits in another way instead of investments

  • Pay down debts to lower risk and interest payments

  • Pay dividends to shareholders

  • Buy back shares to boost stock price

• Business should also consider Qualitative techniques

  • Product life cycle

  • BCG matrix

  • STEEPLE analysis

  • Product portfolio analysis

  • Market research analysis