3.3.2 Investment Appraisal

• • Investment appraisal involves comparing the expected future cash flows of an investment with the initial outlay for that investment
• What key data is needed for investment appraisal?

  • Sales forecasts
  • Fixed and variable costs data
  • Pricing information
  • Borrowing costs
• methods of investment appraisal

  • ARR
  • NPV
  • Payback Period
• What is payback period?

  • a calculation of the amount of time it is expected an investment will take to pay for itself
• Calculation for Payback Period

  .

  A) initial

  B) net cash flow

  
• Benefits of payback period

  • simple method 
  • useful for businesses where cash flow management is vital
  • can identify the point at which an investment is paid back and contributing positively to cash flow
  • useful where new technology is introduced regularly
  • purchasing equipment = can calculate whether investment ‘pays back’ before an upgrade is available
• Drawbacks of payback period

  •  provides no insight into profitability of investments
  • Only considers total length of time to recover an investment
  • Neither the timing nor the future value of cash inflows is considered
  • May encourage a short-termism approach
  • Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives
• What is ARR?

  • The Average Rate of Return compares the average  profit per year generated by an investment with the value of the initial outlay
• Formula for ARR

  A) Average Annual Return

  B) Initial

  
• Outcome of ARR is expressed as a percentage
• Benefits of ARR

  • considers all of the net cash flows generated by an investment over time.
  • Easy to understand & compare percentage returns with each other
• Drawbacks of ARR

  • It depends on average of cash flows, it ignores the timing of those cash flows
  • The opportunity cost of the investment is ignored as values are nether expressed in real terms nor adjustments made for the impact of interest rates and time
• What is NPV?

  •  Is a financial metric used to evaluate the value of an investment or a project
• • he NPV of an investment takes into account the effects of interest rates and time
  • It represents the present value of the future cash inflows minus the present value of the future cash outflows
  • To get the present value, the future value has to be discounted (reduced)
• What does NPV take into account?

  • The fact that that money received in the future is worth less than money received today due to inflation
  • The opportunity cost of not having the money available for other uses
• Calculating NPV

  • The value of all future net cash flows in today’s terms need to be calculated, then discounted using a table.
  • Cost of initial investment is deducted from total of the discounted net cash flows.
  • If sum is positive, = investment likely to be worthwhile
  • If sum is negative = investment is unlikely to be worthwhile
  • Discounted cash flows are calculated using discount tables which allow future cash flows to be expressed in today’s terms
• Benefits of NPV

  • Considers opportunity cost of money.
  • Discount tables are used to calculate forecast future values of net cashflows
  • Businesses may choose different discount tables (20%, 10%, 5% etc)  to adjust the level of risk involved in a project, allowing a range of scenarios to be considered
• Drawbacks of NPV

  • Complicated to calculate & interpret
  • Hard to accurately forecast
  • Selecting an appropriate discount rate can be challenging, and even small changes in the discount rate can significantly impact the calculated NPV
  • Only considers the financial costs and benefits of a project and does not account for non-financial benefits or costs, e.g. environmental damage
• How can long term forecasts be inaccurate?

  • Unexpected increases in costs
  • The arrival of new competitors
  • Changes in consumer tastes
  • Uncertainties due to economic growth or recession
• Limitations of investment appraisal

  • Managers compiling forecasts - may lack experience or may be biased towards a particular investment.
  • Incomplete past data may make forecasting imprecise or mean that confidence in the data used to compile the forecast is limited
• What factors aren't considered while forecasting

  • Finances & availability of external finance to fund the investment
  • The overall corporate objectives 
  • Potential for positive public relations or meeting social responsibility