Revision:Investment appraisal

Investment appraisal involves a series of techniques, which enable a business to financially appraise investment projects. There are three main methods: payback, average rate of return, and net present value (discounting).

PAYBACK

Works out how long it takes to repay the initial investment.

e.g. Investment A. costs £100. Annual return of £25 Length 5 years

YEAR NET CASH FLOW
(ANNUAL RETURN)
CUMULATIVE CASH FLOW
(CASH IN FLOW)
0 -100 -100
1 25 -75
2 25 -50
3 25 -25
4 25 0
5 25 25


Payback is 4 years.


Sometimes it is necessary to calculate the month of payback when the figure is reached part way through the year. To do this you would you use formula:


\displaystyle \mathsf{Calculating\ the\ month} = \frac{\mathsf{income\ required}}{\mathsf{Monthly\ contribution}}

 

ADVANTAGES

  • Easy to calculate
  • Easy to understand
  • Most relevant to businesses with cashflow problems
  • Emphasises speed of return – good in rapidly changing markets

DISADVANTAGES

  • Ignores money received after payback
  • Can be difficult to establish a target payback period
  • Doesn’t consider the future value of money
  • Short term approach

AVERAGE RATE OF RETURN

ompares profit with money invested.

\displaystyle \mathsf{Average\ rate\ of\ return} = \frac{\mathsf{average\ annual\ return\ (profit)}}{\mathsf{Initial\ outlay}} \times 100 = \%


To work this out, break it down into stages.

  • Calculate lifetime profit = total inflows – outflow
  • Divide by the number of years
  • Use the formula


e.g. Investment A cost £100 £25 return for 5 years


1. Inflow – outflow

£125 - £100

= £25


2. Divide by the number of years. 25/5 = 5


3. Use formula

5 / 100 X 100

= 5% return

ADVANTAGES

  • Percentage provides easy comparisons across projects
  • Shows the profitability of a project

DISADVANTAGES

  • Harder and more time consuming
  • Ignores time value of money

NET PRESENT VALUE (DISCOUNTED CASH FLOW)

This takes into account the time value of money. It is based on the principle that money is worth more than it is in the future. The principle exists for two reasons:

  • Risk – money in the future is uncertain
  • Opportunity cost – Money could be in an interest account earning interest.

Discounting

This is the process of adjusting the value of money from its present value to its value in the future. The key to discounting is the rate of interest. The business chooses the most appropriate rate for the life of the project. It then identifies the discounting factor. The amount of money is then multiplied by the discounting factors to convert it to its net present value.


e.g. Project A £100 £25 return 5 years

 

YEAR NET RETURN DISCOUNT FACTOR NET PRESENT VALUE
0 -100 0 -100
1 25 0.952 23.8
2 25 0.907 22.675
3 25 0.864 21.6
4 25 0.823 20.575
5 25 0.784 19.6
= £108.25


£108.25 MINUS INITIAL COST (£100) = £8.25

Profit = £8.25

ADVANTAGES

  • Considers the time value of money
  • Reducing discounting rate reduces future monies more heavily
  • Only one method that gives a definitive answer
  • Positive return – it is worth doing

DISADVANTAGES

  • Time consuming
  • More difficult to understand
  • Based on an arbitrary choice of interest rate

QUALIATIVE FACTORS

Investment appraisal techniques consider the financial results but there are other factors to be considered. These will be different for every organisation.

  • The aims of the business
  • The reliability of the date
  • The economy
  • Image
  • SWOT (strengths, weakness, opportunities, threats) analysis
  • PEST analysis
  • HRM issues
  • Stakeholder analysis
  • Anything else that needs to be considered

Comments

These notes are aimed at people studying for A Level Business Studies (Unit 4), but will be suitable for other people too.

Originally submitted by rachd_22 on TSR Forums.