**Investment Appraisal**

**Introduction**

Investment

refers to the purchase of an asset with the potential to yield future financial benefits.

1. PAYBACK PERIOD

2. Accounting Rate of Return (ARR)

Calculates the average profit on an investment project as a percentage of the amount invested.

Discounted Cash Flow

It's a technique based on the concept of the opportunity cost of money and future cash flows.

Net Present Value

Money received in the future is worth less than if it were received today.

Investment appraisal is the general term referring to the quantitative techniques used to calculate the financial costs and benefits of an investment decision.

It refers to the period of time for an investment project to earn enough profits to repay the cost of the initial investment.

Initial Investment ($) / Contribution per month ($)

Question: Suppose, the construction of a new sports complex that costs $1,000,000 is expected to generate the following net cash flows over the first four years:

Year 1: $210,000

Year 2: $350,000

Year 3: $480,000

Year 4: $450,000

What is the payback period?

Answer: (1) Calculate the cumulative cash flow.

(2) The payback period happens between years ____ and _____.

a. Calculate the difference between the cumulative net cash inflow in year 2 and the amount invested: $1,000,000 - $560,000 equals...

b. Calculate the average monthly cash inflow in year 3:

c. Divide a by b to find the number of months.

The payback period for the project is forecast to be...

EXERCISE

ADVANTAGES

DISADVANTAGES

The simplest and quickest method of investment appraisal.

Useful for firms with cash flow problems

Allows a business to see whether or not it will break-even on the purchase of the asset(s) before it needs to be replaced.

Used to compare different investment projects with different costs (quickest payback period of each option)

Helps to assess projects which will yield a quick return for shareholders

Assesses only the short term (less prone to forecasting errors)

It may encourage a short-termism approach to investment.

The contribution per month is unlikely to be constant as demand is prone to seasonal fluctuations.

Payback focuses on time as the key criterion for investment, rather than on profits.

Total profit during project's lifespan / # of years of project

Initial amount invested

x 100

As a basic benchmark, the ARR can be compared with the base interest rate to assess the rewards for the risk involved in an investment.

Question: Suppose the purchase of a new computer system that costs $400,000 is forecast to generate the following net cash flows over the next five years (when it needs to be replaced):

Year 1: $100,000

Year 2: $200,000

Year 3: $180,000

Year 4: $120,000

Year 5: $100,000

Calculate the ARR for this project.

Answer:

1.

Total net cash inflow over the five years is $700,000

2.

Project profit = $700,000 minus $400,000 for the initial investment = $300,000

3

. Average annual profit = $300,000 / 5 years = $60,000 per year

4

. Hence the ARR = $60,000 / $400,000 = 15%

If the banks are offering a 5% return, how attractive does this project seem?

EXERCISE

Ex.: If you have $100 and decide to place it into a bank account paying 5% interest, at the end of the year you will have $105.

ADVANTAGE

DISADVANTAGE

It enables easy comparisons (in percentage terms) of the forecast proceeds of different investment projects

It ignores the timing of cash inflows and hence is prone to forecasting errors when considering seasonal factors.

A discount factor is used to convert the future net cash flow to its present value today.

Suppose an NPO expects to receive $25,000 in two years time as a donation whilst today's interest rate is 7%. What is the present value of the $25,000?

If you check the table above, the discount factor for 7% interest over 2 years is ????

Hence the present value of the $25,000 in two years time is: $25,000 x ____ = ______

Calculating Discount Factors

1. Determine the interest rate: 7%

2. Workout the cumulative IR: for two years -> (1.07)^2

3. Place this value as the denominator, with 1 as the default numerator:

1 / (1.07)^2 =

NPV = Sum of Present Values - Cost of Investment

QUESTION:

New mechanization for a firm is estimated to cost $500,000 and should last for five years. Maintenance of the machine will cost $65,000 annually but it will generate output for the firm by an estimated of $170,000. Base interest rates are currently 5%. Workout the NPV on the proposed investment.

ANSWER:

1. Calculate the net cash flow per year.

2. Use/calculate the discount factor per period.

Total

3. Calculate the Present Value per year.

4. Total Present Values - Initial Investment

EXERCISE

EXERCISE