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

quantitative

techniques that assess the financial feasibility of the project.

Quantitative

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.

IF

the investment produces

equal

cash flows each year then you can use a

simple

formula.

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

variable

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.

Example:

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?

Year

0

1

2

3

4

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

2

years and

?

months.

2. Calculate number of months

First calculate the monthly average in year 3

60000

12

= 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

5000

= 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.

Advantages:

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

Disadvantages:

it is not a measure of profitability

it

ignores what happens after the payback period

focus on short term could lead to eliminating very profitable investments just because they take more time

Practice:

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.

Year

0

1

2

3

4

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.

Advantages:

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

Disadvantages:

It ignores the timing of cash flows.

The projects useful life span is a guess.

Errors are more likely the longer the time period.

Do:

ARR practice

Case Study

Extensions

Blockbuster Investment Case study:

http://www.forbes.com/sites/stevenbertoni/2011/03/21/billionaire-carl-icahn-calls-blockbuster-his-worst-investment-ever/

**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

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?

Define

ARR

Identify

how to calculate ARR

Examine

which investment project is more attractive

NPV

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