3.8 Investment Appraisals

Investment Appraisals

A scientific approach to investment decision making which investigates the expected financial consequences of an investment in order to assist the company in its choices.

• It is a quantitative tool in the decision making process. Any investment decisions should also take qualitative focus.

• The quality of decision depends on the quality of the data used (“garbage in, garbage out”)

Reasons for investment/capital investment

Investment refers to the process of purchasing non-current (fixed assets) such as buildings, plant machinery or office equipment.

Capital investment takes place to:

• Replace or renew any assets that have worn out (depreciated) or become obsolete (out of date)

• Introduce additional new assets in order to increase capacity and meet increased demand.

Methods on Investment Appraisals

• Payback Method

• Average rate of return (ARR) or annual rate of return or annual average rate of return

• Net Present Value

What do the 3 methods of IA base their recommendations on?

• The initial cost of Investment

• The net return (revenue-costs) per annum

• The lifetime of the investment

Payback Formula

• This method of appraisal is very important when a company has weak cashflow

How do you calculate payback period

• Payback is when cumulative return = 0

• Year column shows when investment is made

• Cumulative return is a running total

• Annual return is the amount made from investment

ARR Formula

Payback +-s

+ Easy for non-accountants to understand and simple to calculate.

+ Emphasis on cash flow rather than profit, so its important where there are cashflow problems.

+ Emphasis on speed of return is useful for fast changing markets e.g. fashion, software.

- Payback ignores any cashflow that occurs after the payback period.

- Focus on payback may encourage short-termism and therefore the business will fail to look at the long term consequences of an investment.

- Values future costs and revenues at the same value as current costs and revenues.

ARR +-s

+ Shows the profitability ( as a %) of the investment or project and can be compared with alternative investments

+ Easy to understand

- Values future costs and revenues at the same value as current costs and revenues

NPV Formula

Annual return × Discount factor

NPV does not use cumulative return

NPV +-s

An important aspect is that NPV recognises that a higher value is placed on money paid/received now than in the future.

+ NPV is the only method that considers the time value of money. For this reason alone, NPV is usually preferred to Payback and ARR.

+ Cash flows that come from far into the future are discounted more heavily, this reduces the influence of long term estimates (which are more reliable).

+ NPV gives a precise answer: a positive NPV means that, on financial grounds, an investment should be undertaken. A negative NPV means that the project should be rejected.

- NPV is time consuming and more difficult to calculate and understand (so decision makers may distrust it).

- The results of the calculations heavily depend on discount rates and the choice of discount rate may be made quite arbitrarily.

How do you comment on Investment appraisals?

• Comment on the amount they can afford

• Info on the cashflows - new company?, risk?, research?, Weakness in cashflow —> payback

• Info on objectives

• Info into NPV

Limitations of quantitative investment appraisals

• Results depend on accurate forecasts and data.

• Future interest rates may change.

• Not all costs and benefits can be measured numerically.

• Ethical and strategic considerations may be ignored.

Qualitative factors affecting investment decisions

• Projections - Managers expectations about the future, such as economic conditions and interest rates.

• Objectives - Different organisations have different goals. Profit may not be the only objective.

• Risk Profile - Risk-averse firms may prefer safer investments with more certain returns.

• State of the Economy - Business confidence, economic growth, and interest rates affect investment decisions

• Corporate Image - The impact on how an investment project will affect their reputation and public perception.

• Human Relations - Effects on employees, morale, productivity, and possible redundancies.

• External Shocks - Unexpected events such as natural disasters, economic crises or supply disruptions.