Investment Appraisal lecturer - week 4

Financial Management Week 4

Investment Appraisal Overview

  • Capital Investment: Refers to spending money on capital assets, essential for long-term success despite not being essential in the short term.

  • Importance of capital investments in keeping products up to date and competitive.

Motives for Investment

  • Replacement of Assets: Updating or replacing existing resources.

  • Acquisition for Expansion: Investing in new assets to grow the business.

  • Innovation: Developing new solutions to reduce costs or create additional value.

Capital Projects

  • Characteristics:

    • Long-term nature

    • Significant investment often required (e.g., £800 million, £189 million, £757 million).

  • Risks of poor decision-making can directly affect strategic objectives.

Investment Financial Justification

  • Investments should yield future profits or savings greater than the costs.

  • Capital Investment Appraisal: Used to assess the financial viability of new projects amid limited cash resources.

Risk in Investment

  • Investment decisions are complicated due to:

    • Multiple alternative options.

    • Reliance on projections of future demand.

    • Long-term commitments and potential reliance on borrowed funds.

Financial Information Required for Appraisals

  • Proposed investment costs.

  • Revenue estimates for new products/services.

  • Demand forecasts for intended offerings.

Net Cash Flow Calculation Challenges

  • Net Cash Flow Example:

    • Year 0: -50,000

    • Year 1: 10,000

    • Year 2: 20,000

    • Year 3: 20,000

    • Year 4: 30,000.

  • Predictions over long periods can be inaccurate due to fluctuating market conditions.

Questioning Projections

  • Before relying on projected figures, managers should investigate:

    • Sources of predictions.

    • Reliability of information.

    • Associated risks.

Approaches to Assess Long-Term Project Feasibility

  1. Payback Period: Measures how quickly an investment will generate enough cash flow to recover the initial outlay.

  2. Accounting Rate of Return (ARR): Compares average profit against the initial investment.

  3. Discounted Cash Flow (DCF): Considers the time value of money to assess investment value.

Payback Method

  • Evaluates the recovery time of an investment using cumulative cash flows.

  • Example Calculations:

    • Project 1 Payback: 4 Years.

    • Project 2 Payback: Between 2 and 3 Years, about 2 Years 8 Months.

    • Project 3 Payback: 2 Years 9 Months.

Accounting Rate of Return (ARR)

  • Calculation Steps:

    • Total profit over the project lifetime divided by project duration to find average annual profit.

    • ARR formula: (Average Annual Profit / Initial Investment) x 100.

  • Projects with the highest ARR are prioritized.

Discounted Cash Flow (DCF)

  • Accounts for the time value of money, highlighting the preference for current cash over future cash.

  • NPV Calculation: Compare present value of future cash flows to the initial investment.

    • A positive NPV indicates a worthwhile investment.

Factors Influencing Investment Decisions

  • Risk and Uncertainty: Factors include project length, investment size, reliability of data, and economic conditions.

  • Qualitative Considerations: Ethical considerations, employee impact, and brand reputation.

Closing Notes

  • Both qualitative and quantitative analyses are essential for sound investment decision-making.

  • Contingency Planning and Sensitivity Analysis assist in handling uncertainties during the investment evaluation process.