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
Scale/Cost of Investment:
Is the investment affordable?
Return Timeframe:
How long before the investment generates returns?
Payback Period:
How long will it take to recover the initial investment?
Expected Profits:
What are the anticipated profits from the investment?
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:
Payback Period
Average Rate of Return
Discounted Payback
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.