Investment Appraisal
Investment Appraisal
Investment Appraisal - Introduction
Investment appraisal involves assessing an investment project to determine its financial worth.
It uses various methods to help businesses decide if a project is worthwhile.
Example: Fishermans Friend Ltd. considering investing in a new factory.
Payback Method
Definition: Calculates the time it takes to recover the initial investment cost.
Breakeven is about output, payback is about time
Steps:
Estimate annual cash inflows.
Account for initial cash outflows (typically in year zero).
Calculate Net Cash Flows (NCFs): Annual Cash Inflows - Annual Cash Outflows.
Calculate cumulative NCFs by adding each year's NCF to the previous cumulative NCF.
Determine when the cumulative NCF turns positive, indicating payback.
Calculate the number of months to achieve payback within that year:
(\text{Remaining cost to recover} / \text{NCF in the year of payback}) \times 12
Evaluate if the payback period is acceptable.
Example (Mr. Landry's Pizza Restaurant):
Initial Investment: $800,000.
Annual Cash Inflows and Outflows (Years 1-4):
Year 1: Inflows = $200,000, Outflows = $20,000, NCF = $180,000
Year 2: Inflows = $400,000, Outflows = $80,000, NCF = $320,000
Year 3: Inflows = $460,000, Outflows = $100,000, NCF = $360,000
Year 4: Inflows = $500,000, Outflows = $100,000, NCF = $400,000
Cumulative NCF for each year:
Year 0: -$800,000
Year 1: -$620,000
Year 2: -$300,000
Year 3: $60,000
Year 4: $460,000
Payback occurs during year 3.
Months to payback: (\frac{300,000}{360,000} \times 12 = 10 \text{ months})
Total Payback Period: 2 years and 10 months.
Evaluation:
A payback of just over two years is relatively quick.
Attractive if risk-averse, especially in rapidly changing markets.
Easy to compare against other projects for non-financial experts.
Ignores cash flows after the payback period.
Ignores inflation and the time value of money.
Average (Accounting) Rate of Return (ARR)
Definition: Calculates the average annual return of a project as a percentage of the initial investment.
Formula:
ARR \ (%) = (\frac{\text{Total of NCFs from investment}}{\text{Number of years of project}} / \text{Initial investment}) \times 100 total NCF/years of project/initial investment)
Steps:
Calculate the sum of the NCFs to find the overall net return from the investment.
Divide the total net return by the number of years for the project.
Divide the result by the initial investment.
Multiply by 100 to get a percentage.
Example (Mr. Landry's Pizza Restaurant):
Initial Investment: $800,000
Net Cash flows (Years 1-4):
Year 1: $180,000
Year 2: $320,000
Year 3: $360,000
Year 4: $400,000
Total NCF: $180,000 + $320,000 + $360,000 + $400,000 = $1,260,000
Net Return: $1,260,000 - $800,000 = $460,000
ARR = (\frac{460,000}{4} / 800,000) \times 100 = 14.38 \%
Evaluation:
14.38% looks good but should be compared to alternative investment options.
Compare to interest rates from a bank account or borrowing costs.
Easy comparisons.
Doesn't account for time value of money
Net Present Value (NPV)
Definition: Calculates the present monetary value of a project's future cash flows.
Adjusts future cash flows using 'discounted cash flows' to account for the time value of money.
Steps:
Choose a discount factor rate (DCF) based on the cost of finance.
Multiply the Net Cash Flow (NCF) figures by the discount factor rate to get Discounted Net Cash Flows.
Sum the discounted Net Cash Flows.
Evaluate the results: positive NPV means the investment is viable; negative NPV means it is not.
Example (Mr. Landry's Pizza Restaurant):
Initial Investment: $800,000.
Discount factor rate: 20%.
Annual Net Cash Flows and Discount Factors:
Year 0: NCF = -$800,000, DCF = 1.00
Year 1: NCF = $180,000, DCF = 0.83
Year 2: NCF = $320,000, DCF = 0.69
Year 3: NCF = $360,000, DCF = 0.58
Year 4: NCF = $400,000, DCF = 0.48
Discounted NCFs:
Year 0: -$800,000
Year 1: $149,400
Year 2: $220,800
Year 3: $208,800
Year 4: $192,000
NPV = -800,000 + 149,400 + 220,800 + 208,800 + 192,000 = -$29,000
Evaluation:
A negative NPV (-$29,000) indicates that the investment is not financially viable when considering the time value of money.
Accounts for the 'time value of money'.
The Discount factor rate (DCF) can be adjusted to allow for changes in economic conditions.
Provides a clear decision: If negative don’t go ahead. If positive, go for the project with the highest NPV.
Comparison of Methods
Feature | Payback | ARR | NPV |
|---|---|---|---|
What it shows | How quickly an investment project pays for itself | Measures the return each year for the project as a percentage of the initial cost on investment | Shows the monetary return on investment for the project when taking into account the effects of interest rates and time ('time value of money') |
Advantages | Simple and easy to understand. Useful for businesses with cash flow problems. | Clearly shows the profitability of an investment. Easy to compare to investment options or opportunity costs. | Accounts for the time value of money. Adjustable Discount factor, Provides a clear decision |
Disadvantages | Ignores the duration of the project and cash flows after payback. | Ignores the 'time value of money'. Uses averages, but returns may not be evenly dispersed. | Complex to calculate. The result depends on the DCF rate used |
Example Results | 2 years and 10 months | 14.38% | -$29,000 |
Other Considerations
Qualitative Factors:
Human relations: Impact on redundancies and culture.
Ethics: Environmental and social impact.
Risk: Future economic outlook.
Availability of funds.
Business confidence.
Accuracy of Data used to compile investment appraisal
Project Duration: shorter time scale projects (2-3 years) can be less risky to predict than longer projects 10-15 years)
Overall Business Objectives: Does project fit with overall business objectives?
Recommendation: Use all three investment appraisal methods and consider qualitative factors.