7.8 - Investment appraisal

• Investment appraisal


  Helps businesses decide what projects to invest in, in order to get the best, fastest, least risky return for their money
• Investment decisions


  • Must balance Risk and Return
• Businesses need to invest


  To achieve their objectives (e.g. increase sales by 25% over three years)
• Investing money


  Spending money in the hope of making money in the future
• Investing is risky because there's always the possibility that you won't make as much money as you expect</b>
• Businesses like the risks to be low and the return (the profit on the investment) to be high
• When making strategic investment decisions

  1. Gather as much data as possible

  2. Work out the risk and reward involved
• Main questions businesses try to answer

  • How long will it take to get back the money that they spend?
  • How much profit will they get from the investment?
• Main investment appraisal methods

  • Average rate of return
  • Payback period calculation
  • Net present value calculation
• Investment appraisal methods


  Assess how much profit a project is going to make, and how fast the money will come in
• The faster money comes in, the less risk in the long run
• Investment appraisal methods are only as good as the data used to calculate them
• Average Rate of Return (ARR)


  Compares Net Return with Investment
• Average rate of return (ARR)

  Compares the net return with the level of investment. The net return is the income of the project minus costs, including the investment.
• The higher the ARR


  The more favourable the project will appear
• ARR


  Expressed as a percentage
• Payback


  The Length of Time it takes to Get Your Money Back
• Payback period


  The time it takes for a project to make enough money to pay back the initial investment
• Managers compare payback periods


  1. To choose which project to go ahead with

  2. Prefer a short payback period
• Advantages and Disadvantages of ARR and Payback

  • ARR Advantages
  • Payback Period Advantages
  • ARR Disadvantages
  • Payback Period Disadvantages
• ARR Advantages


  • Easy to calculate and understand
  • Takes account of all the project's cash flows
• Payback Period Advantages


  • Easy to calculate and understand
  • Good for high tech projects or projects that might not provide long-term returns
• ARR Disadvantages


  • Ignores the timing of the cash flows
  • Ignores the time value of money
• Payback Period Disadvantages


  • Ignores cash flow after payback
  • Ignores the time value of money
• Future Value of cash inflow

  Depends on Risk and Opportunity Cost
• Risk and opportunity cost increase the longer you have to wait for money


  It's worth less
• Time value of money

  The worth of money decreases over time
• Someone offers you £100 cash-in-hand now or £100 in one year's time

  You'd be best off taking it now
• There's a risk that the person would never pay you the £100 after a year had gone by
• In a year's time the money would be worth less due to inflation-a general rise in prices over time
• There's an opportunity cost if you had the money now you could invest it instead of waiting for it
• A high interest account would beat the rate of inflation and the £100 plus interest that you'd end up with in a year's time would be worth more than the £100 in your hand today, and much more than the £100 would be worth to you in a year
• A payment after a year or two, or three, is always worth less than the same payment made to you today
• Discounting


  Adjusts the value of Future Cash Inflows to their Present Value
• Discounting


  1. Multiplying the amount of money by a discount factor

  2. Discount factors are always less than 1, because the value of money in the future is always less than its value now
• Discount factors


  Depend on what the interest rate is predicted to be
• High interest rates


  Future payments have to be discounted a lot to give the correct present values
• Low interest rates


  Future cash inflow doesn't need to be discounted so much
• Net Present Value (NPV)

  Used to calculate return
• Discounted cash flow (DCF)


  Investment appraisal tool that uses the net present value (NPV) to calculate the return of the project