Baba investment appraisal

What is investment appraisal?

Investment appraisal involves comparing the expected future cash flows of an investment with the initial outlay for that investment. A business may want to analyse:

· How soon the investment will recoup the initial outlay

· How profitable the investment will be

Before an investment can be appraised, key data will need to be collected, including:

· Sales forecasts

· Fixed and variable costs data

· Pricing information

· Borrowing costs

The collection and analysis of this data is likely to take some time. It requires significant experience to interpret the data appropriately before the investment appraisal can take place.

Different methods are used to appraise the value of an investment, including:

· The simple payback period

· The average rate of return (ARR)

· The net present value of discounted cash flow

What is the payback period and how is it calculated?

The payback period is a calculation of the amount of time it is expected an investment will take to pay for itself.

Where net cash flows are expected to be constant over time, the payback period can be calculated using the formula: Payback period = Initial outlay ÷ Net cash flow per period = Years / months.

Worked Example: Gomez Carpets is considering an investment in a new storage facility at a cost of £200,000. It expects additional net cash flow of £30,000 per year as a result of the investment.

Step 1: Divide the initial outlay by the additional expected net cash flow = £200,000 ÷ £30,000 = 6.67 years

Step 2: Convert the outcome to years and months. 6 years. 0.67 years = 8.04 months. Payback period = 6 years and 8 months.

How do you calculate the payback period when net cash flows vary? (Worked example)

Hammer and Son provides a household repairs service that has recently employed a new handywoman who requires her own van. The new van will be purchased for £32,000. The net cash flows are expected to vary over the five years following its purchase and are shown in the table below.

Year Net cash Flow (£) Cumulative Cash Flow (£)

0 (32,000) (32,000)

1 14,000 (18,000)

2 10,000 (8,000)

3 6,000 (2,000)

4 3,000 1,000

5 2,000 3,000

Calculate the payback period for the van.

Step 1: Identify the final year where the cumulative cash flow is negative. In this case the cumulative cash flow figure is -£2,000 at the end of Year 3. This is the remaining amount (outlay) outstanding.

Step 2: Calculate the monthly net cash flow for the next year = £3,000 ÷ 12 (months) = £250

Step 3: Divide the remaining outlay outstanding by the monthly net cash flow = £2,000 ÷ £250 = 8 months

Step 4: Identify the payback period. In this case the Payback period is 3 years and 8 months.

What are the benefits and drawbacks of the payback period method?

Benefits:

· It is a simple method to calculate and understand

· It is particularly useful for businesses where cash flow management is vital

· Businesses can identify the point at which an investment is paid back and contributing positively to cash flow

· It is also useful where new technology is introduced regularly

· Businesses purchasing equipment can calculate whether an investment 'pays back' before an upgrade is available

Drawbacks:

· It provides no insight into the profitability of investments

· Payback only considers the total length of time to recover an investment

· Neither the timing nor the future value of cash inflows is considered

· It may encourage a short-termism approach

· Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives

What is the average rate of return (ARR) and how is it calculated?

The average rate of return compares the average profit per year generated by an investment with the value of the initial outlay. The average rate of return is calculated using the formula: ARR = (Average annual return ÷ Initial outlay) × 100.

The outcome of the formula is expressed as a percentage, which makes it easy to compare different investment options.

Worked Example: Creative Frames, a small artwork framing business, is considering an investment of £40,000 in new machinery. Megan, the business owner, believes that total cash inflows over a 6-year period will be £140,000 and total cash outflows will be £92,000.

Step 1: Calculate the total profit over the lifetime of the investment. Total cash inflows - Total cash outflows = Total profit = £140,000 - £92,000 = £48,000

Step 2: Divide the total profit by the number of years of the investment project to find the average annual profit = £48,000 ÷ 6 years = £8,000

Step 3: Divide the average annual profit by the initial outlay = £8,000 ÷ £40,000 = 0.2

Step 4: Multiply the outcome by 100 to find the percentage = 0.2 × 100 = 20%

What are the benefits and drawbacks of the average rate of return?

Benefits:

· It considers all of the net cash flows generated by an investment over time

· It is easy to understand and compare the percentage returns with each other

Drawbacks:

· As it depends on an average of cash flows, it ignores the timing of those cash flows

· The opportunity cost of the investment is ignored as values are neither expressed in real terms nor adjustments made for the impact of interest rates and time

What is net present value (NPV)?

Net Present Value (NPV) evaluates the value of an investment or a project. It takes into account the effects of interest rates and time. It represents the present value of the future cash inflows minus the present value of the future cash outflows. To get the present value, the future value has to be discounted (reduced). This discounting method recognises:

1. That money received in the future is worth less than money received today due to inflation

2. The opportunity cost of not having the money available for other uses

To calculate the Net Present Value of an investment, the value of all future net cash flows in today's terms need to be calculated first - and then discounted using a table. The cost of the initial investment is deducted from the total of the discounted net cash flows. If future net cash flows minus the initial investment is positive, then the investment is likely to be worthwhile. If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile. Discounted cash flows are calculated using discount tables which allow future cash flows to be expressed in today's terms.

How do you calculate net present value (NPV)? (Worked example)

Brownsea Sightseeing Tours Ltd is considering purchasing a new pleasure craft at a cost of £325,000. It expects the investment to achieve the following net cash flows over five years of operation.

Year Net cash Flow (£) 10% Discount Factor

0 (325,000) 1.00

1 110,000 0.91

2 90,000 0.83

3 75,000 0.75

4 65,000 0.68

5 60,000 0.62

Using the 10% discount factor, calculate the NPV of the leisure craft investment.

Step 1: Calculate the discounted cash flow for each year by multiplying the net cash flow by the discount factor.

Year Net cash Flow 10% Discount Factor Discounted cash flow

0 (£325,000) 1.00 (£325,000)

1 £110,000 0.91 £100,100

2 £90,000 0.83 £74,700

3 £75,000 0.75 £56,250

4 £65,000 0.68 £44,200

5 £60,000 0.62 £37,200

Step 2: Add together the discounted cash flow values for each year, including Year 0 = (£325,000) + £100,100 + £74,700 + £56,250 + £44,200 + £37,200 = (£12,550). The net present value of the investment is -£12,550. This suggests that the investment in the new pleasure craft is not financially worthwhile.

What are the benefits and drawbacks of the net present value method?

Benefits:

· It considers the opportunity cost of money

· Discount tables are used to calculate forecast future values of net cashflows

· Businesses may choose different discount tables (20%, 10%, 5% etc) to adjust the level of risk involved in a project, allowing a range of scenarios to be considered

Drawbacks:

· It is more complicated to calculate and interpret than other methods of investment appraisal

· Accurately forecasting future cash flows can be difficult

· Selecting an appropriate discount rate can be challenging as even small changes in the discount rate can impact the calculated NPV

· The NPV method only considers the financial costs and benefits of a project

Examiner Tip: With ARR or NPV, always compare options clearly and explain what the results mean for a business - don't just state the numbers.

What are the limitations of investment appraisal?

Each technique relies upon forecasted future cash flows, which may lack accuracy. Managers may lack experience or may be biased towards a particular investment. Incomplete past data may make forecasting imprecise or mean that confidence in the data is limited.

Longer-term forecasts used to predict returns on investments may be inaccurate for a variety of reasons:

· Unexpected increases in costs

· The arrival of new competitors

· Changes in consumer tastes

· Uncertainties arising as a result of economic growth or recession

Non-financial factors are ignored:

· Business finances and availability of external finance to fund the investment

· Overall corporate objectives

· Potential for positive public relations or meeting social responsibilities

What are the common investment criteria? (Expected profits and availability of finance)

Businesses consider a range of criteria when deciding whether to invest in, for example, capital equipment, training or R&D.

1. Expected profits compared to costs: Businesses ask whether an investment is likely to earn more money back than it costs. They compare how much extra profit a project should bring to decide if it's worth doing.

2. Availability and cost of finance: They look at how easy and cheap it is to borrow money. Low interest rates can be an incentive to take out loans for big purchases.

What are the common investment criteria? (Cash flow, government incentives and market demand)

Cash flow and internal funds: They consider how much spare cash is available to fund or repay borrowing used to fund an investment. Even if borrowing is possible, they won't start a project if it leaves them unable to pay day-to-day bills.

4. Government tax breaks and grants: Government schemes, such as tax credits for research spending or grants for new machinery, cut the cost of an investment and make them more attractive.

5. Market demand and competitive pressure: Businesses invest when customers are asking for new products or when rivals are upgrading. If demand is rising or competitors are innovating, businesses must spend to keep up.

What non-financial factors affect investment decisions? (Technological change and regulatory environment)

Although quantitative investment criteria usually drive investment decisions, businesses consider a range of non-financial factors, too.

Technological change: Companies invest to keep up with new technology that boosts efficiency or quality. Example: Jaguar Land Rover fitted advanced welding robots at its Solihull plant to build cars faster and with fewer defects.

Regulatory and legal environment: New laws or standards may force firms to upgrade systems or processes to stay compliant. Example: After GDPR began in 2018, British Airways spent over £50 million on IT security and staff training to protect customer data.

What non-financial factors affect investment decisions? (Social trends, sustainability and skilled labour)

Social and consumer trends: Changes in customer behaviour lead businesses to invest in new channels or products. Example: Marks & Spencer expanded its website, mobile app and click-and-collect lockers to meet growing online shopping demand.

Environmental and sustainability goals: Climate targets and green regulations push businesses to invest in clean technology projects. Example: Drax Group recently invested £2 billion in bioenergy carbon capture at its North Yorkshire power station to cut CO2 emissions.

Availability of skilled labour: A shortage of key skills encourages businesses to fund training programmes or locate where talent is plentiful. Example: Rolls-Royce has partnered with local colleges and universities to create aerospace apprenticeships, ensuring a steady stream of skilled engineers.

How do risk and uncertainty affect investment decisions?

When businesses decide whether to invest in a new project, like buying machinery, launching a product or building a factory, they weigh up both risk and uncertainty. Risk is where a business can estimate possible outcomes and their probabilities. Uncertainty is where they cannot make these estimates.

Type Factors How it affects investment decisions

Risk Price fluctuations (e.g. raw material costs may rise); Demand swings (e.g. sales might fall if customers buy less) Firms only invest if they expect extra profit to cover possible cost increases, or they add a safety margin in their plans. Companies look for very strong sales forecasts before agreeing to large spends, or they start with a small trial project

Uncertainty Future Regulations (e.g. new laws or standards could change); Technological Change (e.g. new technology may make equipment obsolete); Economic Outlook (e.g. whether the economy will grow) Businesses often delay big projects until rules are clear, or they split them into stages so they can adjust plans later. Managers may wait to see which technology wins out, choose machines that are easy to upgrade or lease instead of buying outright. Firms phase spending by doing part of the project now and adding more later if the economy improves to avoid huge up-front risk