3.8 Investment appraisal

Investment

Capital expenditure or the purchase of assets with the potential to yield future financial benefits

• Eg upgrading computer equipment / purchase of a building

Investment appraisal

• A financial decision-making tool

• Helps managers determine whether certain investment projects should be undertaken based mainly on quantitative techniques

• Evaluates costs + benefits of an investment decision

Qualitative investment appraisal

Judging whether an investment project is worthwhile thru non-numerical techniques

• Eg determining whether the investment is consistent with the corporate culture

Quantitative investment appraisal

Judging whether an investment project is worthwhile based on numerical (financial) interpretations

• PBP, ARR and NPV methods

3 methods of investment appraisal

1. Payback period- PBP

2. Average rate of return- ARR

3. Net present value- NPV

Payback period PBP

An investment appraisal technique that calculates the length of time it takes to recoup (earn back) the initial expenditure on an investment project

• Amt of time needed for an investment project to earn enough profits to repay the initial cost of the investment

2 methods to calculate payback period- PBP

1. PBP formula

2. Cumulative cash flow method

PBP equation

Initial investment cost / contribution per month

Cumulative net cash flow

Sum of an investment project's NCFs for a particular year plus the NCFs of all previous years

Betw the 2 methods to calculate PBP, which is more accurate + why?

Cumulative cash flow method

• Bc income from investment differs each year

Cumulative cash flow method to calculate PBP

1. Make table with year, NCF, cumulative NCF (include Y0)

2. Identify betw which years the cost of investment will be paid back

3. Cost of investment - cumulative NCF for calendar year b4 the investment will be paid back

• no need to do this if year 0 is included in the table

1. Calc avg monthly CF for calendar year in which the cost of investment is paid back

2. Amt left / monthly CF

Calculate PBP using cumulative CF method

PBP = (amt left / cash inflow) x 12

• 2 years 11 months

Calculate PBP using PBP formula:

• Firm will purchase asset, cost = $10,000

• Anticipated financial gain = $6,000 of revenue per year after maintenance costs are paid for

(10,000 / (6000/12)) = 20 months

Pros of using PBP

1. Simplest + quickest method

2. Useful for firms with CF problems → see how fast can recoup cash

3. Can see if business will break even on the purchase b4 it needs to be replaced

4. Can use tocompare diff investment projects

5. Assesses only ST → less prone to errors

6. Managers assess projects which yield a quick return for shareholders

Cons of using PBP

1. Not constant contribution per month → longer PBP

2. Focuses on time, not profit

3. ST approach to investment

4. PBP calculations prone to errors

5. PBP not suitable for some business

Why is contribution per month unlikely to be constant?

Bc demand is prone to seasonal fluctuations → PBP might take longer

The longer the PBP…

The more risky the investment is

Exam tip: just bc something is high risk, does it mean a business should avoid it?

No

• Need to know if benefits of the risks are likely to outweigh the costs

Exam tip: when using PBP should you reject a project just bc it isn’t expected to pay off quickly + why?

No

• Bc it may be v profitable in the LT

• Consider context

Average rate of return- ARR

Calculates the average annual profit of an investment project as a percentage of the initial amt of money invested

ARR equation

(((total returns - capital cost) / years of use) / capital cost)

x 100

• aka (AAP / COI) x100

How to calculate ARR

1. Calc total net CF over years of project

2. Calc expected profit from the project

• Project profit = total returns - capital cost

• Basically total NCF - COI

3. Div by no. of years

4. Div by COI

5. x 100

Project profit equation

Total returns - capital cost

• Or total NCF - COI

Calculate ARR practice question

• Cost of investment = $400,000

15%

• 700 - 400 = 300

• 300 / 5 = 60

• 60 / 400 = 0.15

• 0.15 × 100 = 15%

What does ARR measure?

Profitability

• Not cash flow

As a basic benchmark, what can ARR be compared with?

Base interest rate in the economy

• So can assess rewards + risks involved in the investment

Pros of ARR

1. Easy to understand, calc, compare→ aids decision making

2. Focuses on profitability

Cons of ARR

1. Ignores NCF → prone to forecasting errors

2. Focuses on profit instead of cash flow

3. Figures are only estimates bc based on projects useful life (maybe pure guess)

4. Longer time = more errors

Net present value- NPV

Calculates the total discounted NCFs minus the initial cost of an investment project

• Works out the present value of the return on an investment

What does it mean if NPV is positive?

Project is viable on financial grounds

Discounting

Reverse of calculating compound interest

Discount factor

The number used to reduce the value of a sum of money received in the future to determine its present (current) value

• Used to convert the future NCF to its

  present value today

• Based on inflation / interest rates

Discounted cash flow

Uses a discount factor to reduce the value of money received in future years bc money loses its value over time

NPV equation

Sum of present values - original cost

• Aka sum of all discounted cash flows - cost of investment

How to calculate NPV

1. Find NCF for each year

2. NCF x discount factor = present value

3. Add tog all present values

4. Sum of present values - og cost = NPV

Calculate the NPV for this investment project

• Cost of investment = $400,000

$21,240

Pros of NPV

Cons of NPV

1. NPV value would be reduced if interest rates increase

2. NPV calculations are complex

3. NPV results are only comparable if the initial investment cost is the same between competing projects

Good value for NPV

Must be positive

• Higher the better

Summary of quantitative investment appraisal methods

PBP- risk + time

ARR- profitability

The longer the time period of the project considered…

… the lower the present value of that future amt of money

• Bc money received in the future is worth less than if it were received today

Principal (capital outlay)

The og amount spent on an investment project

What does it mean if NPV is positive + what does this mean?

It is greater than the principal

• The value of the discounted (future) net CFs are enough to justify the initial cost of the investment

What does it mean if NPV is negative?

The investment project is not worth pursuing on financial grounds

Why is cash received in the future not the same value as if it were received today?

Bc:

1. The money could have been invested to generate financial returns

2. Inflation reduces the value of money in the future

How are PBP, ARR, NPV expressed?

1. PBP- time (years, months)

2. ARR- %

3. NPV- monetary value

Qualitative investment appraisal methods that affect investment decisions

PORSCHE

1. Projections

2. Objectives

3. Risk profiles

4. State of the economy

5. Corporate image

6. Human relations

7. External shocks