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3.8 Investment Appraisal

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Laura Murphy

on 20 October 2015

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Transcript of 3.8 Investment Appraisal

Methods of quantitative investment appraisal
payback period
average rate of return
net present value using discounted cash flows (HL)
What is investment appraisal?
Investment appraisal
means evaluating the profitability or desirability of an investment project. It is undertaken by using
techniques that assess the financial feasibility of the project.

investment appraisal requires the following information:

the initial capital cost of the investment
the estimated life expectancy
the residual value of the investment (what it is worth at the end)
the forecast net returns or net cash flows from the project
3.8 Investment Appraisal
Cash-flow uncertainties
For each of the following investment projects explain one reason why there is likely to be some uncertainty about the future net cash-flow forecasts earned by them:

a project to construct a factory to make large and expensive luxury cars
an investment into a new computerized banking system offering customers new services using state-of-the-art equipment that has not been thoroughly tested
cash-flow forecast for a new sports center that are based on a small market research sample of the local population
the building of a new toll motorway between two cities
the construction of an oil-fired power station
Payback method
Payback period
is the length of time it takes for the net cash inflows to pay back the original capital cost of the investment.

The payback period lets you see the level of profitability of an investment in relation to time. The shorter the time period the better the investment opportunity.

To calculate payback period you need to know the cost of the project and the annual expected cash flows.

the investment produces
cash flows each year then you can use a

Payback Period = Cost of project
Annual Cash inflow
Equal annual cash flow examples:

Software costs $150 000 and will generate $50 000 in each year for 4 years.
Investment means purchasing capital goods - such as equipment, vehicles and new buildings - and improving existing fixed assets.
All of the techniques used to appraise investment projects require forecasts to be made of future cash flows. These figures are referred to as "net cash flows".

Annual forecasted net cash flow =

Forecasted cash inflows - forecasted cash outflows
1. Set up a cash flow table
Advantages and Disadvantages of Payback
Average Rate of Return (ARR)
Calculating the ARR
ARR Example
ARR Comparison
Advantages and Disadvantages
A project costs $2 million and is expected to payback $500 000 per year.
When there are
cash flows, a different method needs to be used. This involves setting up a cash flow table and then using a formula to determine the exact amount of months in the payback time.
A business plans to make a $100 000 investment in a computer system that will bring in the following cash flows:

Year 1 - 30 000
Year 2 - 40 000
Year 3 - 60 000
Year 4 - 65 000

What is the payback period to the nearest month?
Net Cash Flow
(100 000)
30 000
40 000
60 000
35 000
Cumulative Cash Flow
(100 000)
(70 000)
(30 000)
30 000
65 000
Looking at the table you can see that payback will be in the third year.
Payback is
years and
2. Calculate number of months
First calculate the monthly average in year 3
= 5000 contribution per month
Second, calculate the month of payback

income required
contribution per month
What is the amount owing in the year before there is positive cash flow (year 2 in this example)? 30 000
Contribution = 5000 (calculated first)
30 000
= 6
Payback is 2 years and 6 months.
Payback is often used as a quick check on the viability of a project or as a means of comparing projects. It is rarely used in isolation from other investment appraisal methods.
it is quick and easy to calculate
the results are easily understood by managers
it can be used to eliminate projects that give returns too far in the future
it allows business to see whether it will break even on an asset before it has to be replaced

it is not a measure of profitability

ignores what happens after the payback period
focus on short term could lead to eliminating very profitable investments just because they take more time
Payback Period Question on Chelsea FC
Average rate of return (ARR) measures the annual profitability of an investment as a percentage of the initial investment.
The formula is:

ARR (%) = Annual Profit (net cash flow) x 100
initial capital cost
This may also be referred to as the accounting rate of return. The ARR allows managers to compare the rate of return on investment projects.
The ARR can be compared with the base interest rate to assess the rewards for the risk involved in an investment.
Annual profit = total profit / # of years of project
There are four stages in calculating ARR:

1. Add up all positive cash flows

2. Subtract cost of investment

3. Divide by life span

4. Calculate the % return to find the ARR
Below is the expect cash flows from a business investment into a fleet of new fuel-efficient vehicles.
Net Cash Flow
($5 million)
$2 million
$2 million
$2 million
$3 million
1. Add up + cash flow - $ 9 million
2. Subtract cost of investment - 9 - 5 = 4 million
3. Divide by life span - 4/4 = 1 million
4. Calculate the ARR - 1/5 x 100 = 20%
This means that over the life span of the investment it can expect a 20% annual return on its investment.
The expected ARR could be compared with:

The ARR of other projects.
The minimum expected return set by the business - known as the criterion rate.
The annual interest rate on loans - if the ARR is less than the interest rate it will not be worthwhile to take a loan to invest in the project.
Evaluation of ARR
ARR is a widely used measure for appraising projects, but it is best considered together with payback results. The two results then allow consideration of both profits and cash-flow timings.
It enables easy comparisons.
It focuses on profitability.
The result is easily understood and easy to compare with other projects.
The result can quickly be assessed against the predetermined criterion rate of the business

It ignores the timing of cash flows.
The projects useful life span is a guess.
Errors are more likely the longer the time period.
ARR practice
Case Study
Blockbuster Investment Case study:
LQ: What factors are taken into consideration before making an investment?
Learning Objectives

Define investment
Calculate PBP
Evaluate the effectiveness of payback period as an investment appraisal tool

Advantages and Disadvantages of Payback?

ARR Solution
How do firms decide whether to make an investment or not?
how to calculate ARR
which investment project is more attractive
calculates the total discounted cash flows minus the initial cost of a particular investment project.
if the NPV is positive, then the project is viable on financial grounds.

NPV= Sum of present values - cost of investment
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