KW

Investment Appraisal Notes

Investment Appraisal

Investments

  • Investment is a crucial area of long-term decision-making. It involves:

    • Using financial resources to acquire assets (e.g., machines, buildings) that generate returns for an organization over time.

  • Investment Appraisal:

    • Evaluating the profitability or desirability of an investment project.

Key Considerations in Investment Decisions

  1. Scale/Cost of Investment:

    • Is the investment affordable?

  2. Return Timeframe:

    • How long before the investment generates returns?

  3. Payback Period:

    • How long will it take to recover the initial investment?

  4. Expected Profits:

    • What are the anticipated profits from the investment?

  5. Alternative Investments:

    • Could the money be invested elsewhere to achieve higher returns?

Information Required for Investment Appraisal

  • Initial Cost:

    • The initial cost of the investment.

  • Life Expectancy:

    • The expected duration the investment will generate returns (in years).

  • Residual Value:

    • The value of the investment at the end of its useful life.

  • Forecasted Net Returns/Cash Flows:

    • The projected net returns or net cash flows from the project.

  • Opportunity Cost:

    • The potential returns from alternative investments.

  • Investment appraisals rely on future forecasts, which are approximations and don't account for all future economic conditions.

Investment Appraisal Methods

  • The main quantitative methods for investment appraisal are:

    1. Payback Period

    2. Average Rate of Return

    3. Discounted Payback

    4. Net Present Value

Payback Method

  • Definition: The length of time required for net cash inflows to recover the initial investment.

  • Formula:

    • Payback Period = \frac{Initial\ Payment}{Annual\ Cash\ Inflow}

  • Calculation of Month of Payback:

    • Month\ of\ Payback = \frac{Additional\ Cash\ Flow\ Needed\ (Amount\ still\ remaining)}{Annual\ Cash\ Flow\ for\ that\ year} \times 12

Payback Method - Example

  • Scenario:

    • A £4 million investment aims to generate £500,000 per year in net cash earnings.

  • Calculation:

    • P = \frac{£4,000,000}{£500,000} = 8\ years

Payback Method - Example 2

Year

Annual Net CF ()

Cumulative CF ()

0

(500,000)

(500,000)

1

300,000

(200,000)

2

150,000

(50,000)

3

150,000

100,000

  • Calculation:

    • Month\ of\ Payback = \frac{50,000}{150,000} \times 12 = 4th\ Month

  • Overall Payback Period:

    • 2 years and 4 months

Interpretation of Payback Period

  • A shorter payback period is generally preferred because:

    • Returns are generated more quickly.

    • The investment is considered less risky.

    • There is less opportunity cost.

    • If financed by borrowing, it results in lower interest payments.

    • The value of money is higher due to inflation.

Payback Method - Advantages

  • Simplicity:

    • Quick and easy to calculate.

  • Easy to Understand:

    • The concept is easily understood by stakeholders.

  • Focus on Speed of Returns:

    • Highlights how quickly the investment will pay for itself.

  • Risk Reduction:

    • Helps eliminate projects with long-term returns, reducing risk.

  • Liquidity Focus:

    • Prioritizes liquidity over long-term profitability.

Payback Method - Disadvantages

  • Ignores Overall Profitability:

    • Cash flows after the payback period are not considered, so overall profitability is ignored.

  • Short-Term Focus:

    • Favors investments with quick returns, potentially overlooking long-term benefits.

  • Unreliable Cash Flow Projections:

    • Relies on future cash flow projections, which can be unreliable.