02 investment appraisal 1

8/2/2019 02 Investment Appraisal 1

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Investment Appraisal

Mrs Gordon

A2 business


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Aims

For you to be able to understand theconcepts of payback, ARR & NPV

To be able to calculate InvestmentAppraisal methods.


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A means of assessing whether aninvestment project is worthwhile ornot

Investment project could be the purchaseof a new PC for a small firm, a new pieceof equipment in a manufacturing plant, awhole new factory, etc


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Investment Appraisal Types of

investmentappraisal:

Payback Period

Average Rate ofReturn (ARR)

Net Present Value(discounted cashflow)

What factors need to be considered beforeinvesting in equipment such as this?

Source: Gergely Erno, http://www.sxc.hu
http://www.sxc.hu/browse.phtml?f=download&id=137798


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Investment Appraisal Why do companies invest?

Importance of remembering investment as thepurchase of productive capacity NOT buying stocksand shares or investing in a bank!

Buy equipment/machinery or build new plant to:

Increase capacity (amount that can be produced)which means:

Demand can be met and this generates salesrevenue

Increased efficiency and productivity


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Investment Appraisal Investment therefore

assumes that theinvestment will yield futureincome streams

Investment appraisal is allabout assessing theseincome streams againstthe cost of the investment

Not a precise science!

A fork lift may be an important item butwhat does it contribute to overall sales?How long and how much work would it haveto do to repay its initial cost?

Source: Loisjune, http://www.sxc.hu
http://www.sxc.hu/browse.phtml?f=download&id=172219


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Looking at thefigures

A failing farmer wants toinvestigate the financialimplications of possible

farm diversification.We looked at thislast lesson!


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Farm Diversification the 3options

Project A B C

Years Quad bikes Paintball Fish hatchery

0 (20,000) (20,000) (10,000)

1 10,000 200 0

2 10,000 200 0

3 5,000 16,000 0

4 5,000 16,000 18,000

Payback 2 years 3 years 3 mths 3 years 7 mths

NPV * 7000 7522 4760

ARR 12.5% 15.5% 20%

So what do otherfactors should the

farmer consider

before deciding on

which project to gowith?


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What other factors?State of the farming industry

Price of land

Interest rates

The economy growing or shrinking?

The farmers interests no good doingsomething the family has no interest in!

Competition in area

Level of demand for each option!


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Collect a booklet



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Payback Method The length of time taken to repay the initial

capital cost

Requires information on the revenue theinvestment generates

E.g. A machine costs 600,000

It produces items that sell at 5 each and

produces 60,000 units per year Payback period will be 2 years


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Payback method

Payback could occur during a year

Can take account of this byreducing the cash inflows from theinvestment to days, weeks or years.

The exam board expect you to calculate paybackto years & months only!


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Payback Method

e.g. Cost of machine =

600,000

Annual income streamsfrom investment =255,000 per year

Payback is some

where between Year 2 & year 3 it willpay back butwhen?

Income

Year 1 255,000

Year 2 255,000

Year 3 255,000

Payback formula

= 600,000255,000

= 2.35 years

Whats just over a 1/3 of a year?= 4 months

= 2 years and 5 months

Payback formula

2 years = 255,000 + 255,000 = 510,000

= 2 years & some months.

600,000 - 510,000 = 90,000 still owing

255,000 = 21,25012 months

= 90,000 = 4.235 month21,250

= 2 years and 5 months


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Now to theworksheet

Do the Payback activities


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Average Rate of Return

A comparison of the profit generated bythe investment with the cost of theinvestment

Average annual return or annual profit

ARR = --------------------------------------------

Initial cost of investment


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Accounting Rate of Return An investment is expected to yield cash flows of 10,000 annually

for the next 5 years.

The initial cost of the investment is 20,000 Total profit therefore is: 30,000

(50,000-20,000)

Annual profit = 30,000 / 5= 6,000

ARR = 6,000/20,000 x 100= 30%

Is this a worthwhile return?Need to compare to interest rates

as well alternatives.


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ARR- do you need a formula? Total revenue (over lifetime) purchase price = total profit

Total profit / life time of product = average profit

Average profit / purchase price = ARR x 100

= ARR %


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Now to theworksheet

Do the ARR activities


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To make a moreinformed decision,more sophisticatedtechniques need to

be used.

Importance oftime-value ofmoney


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Net Present Value Takes into account the fact that money values

change with time

How much would you need to invest today to

earn x amount in x years time?

Value of money is affected by interest rates

NPV helps to take these factors into consideration

Shows you what your investment would haveearned in an alternative investment regime


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Net Present Value e.g.

Project A costs 1,000,000

After 5 years the cash returns = 100,000 (10%)

If you had invested the 1 million into a bankoffering interest at 12% the returns would begreater - You might be better off re-considering

your investment!

Current interest rates are ???

Approx 1% (summer 2009: had been 6% in 2005)


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Net Present Value The principle:

How much would you have to invest now to earn100 in 1 years time if the interest rate was 5%?

The amount invested would need to be: 95

Allows comparison of an investment by valuingcash payments on the project and cash receipts

expected to be earned over the lifetime of theinvestment at the same point in time, i.e thepresent.


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Net Present ValueFuture Value

PV = -----------------(1 + i)n

Where i = interest raten = number of years

The Present Value of 1 @ 10% in 1 years time is0.9090.

If you invested 0.9090p today and the interest rate was10% you would have 1 in a years time

Process referred to as:Discounting Cash Flow

Dont

need to

know this

formula!!


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Net Present Value

Cash flow x discount factor = present value

e.g. PV of 500 in 10 years time at a rate of

interest of 4.25% = 500 x .6595373 = 329.77

329.77 is what you would have to invest todayat a rate of interest of 4.25% to earn 500 in 10years time

PVs can be found through valuation tables

(Always given to you in exams!)


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Discounted Cash Flow An example:

A firm is deciding on investing in an energyefficiency system. Two possible systems areunder investigation

1 yields quicker results in terms of energysavings than the other but the second may bemore efficient later

Which should the firm invest in?


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Discounted Cash Flow System A

Year Cash Flow () Discount Factor(4.75%)

Present Value ()

(CF x DF)

0 - (600,000) 1.00 -(600,000)

1 +75,000 0.9546539 71,599.04

2 +100,000 0.9113641 91,136.41

3 +150,000 0.8700374 130,505.61

4 +200,000 0.8305846 166,116.92

5 +210,000 0.7929209 166,513.39

6 +150,000 0.7569650 113,544.75

Total 285,000 NPV =139,416

Watch this.


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Discounted Cash Flow System B

Year Cash Flow () Discount Factor(4.75%)

Present Value ()

(CF x DF)

0 - (600,000) 1.00 -(600,000)

1 +25,000 0.9546539 23,866.35

2 +75,000 0.9113641 68,352.31

3 +85,000 0.8700374 73,953.18

4 +100,000 0.8305846 83,058.46

5 +150,000 0.7929209 118,938.10

6 +450,000 0.7569650 340,634.30

Total 285,000 NPV =108,802.70

Watch this.


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Discounted Cash Flow System A represents the better

investment. But why?

System B yields the same cash return after 6years but the NET returns of System A occurfaster and are worth more to the firm thanreturns occurring in future years even thoughthose returns are greater

Absolutely vital to

remember this for

evaluation!

What would youprefera 50

today or 100 in3 years time?


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Now to theworksheet

Do the NPV activities


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Investment Appraisal Key considerations for firms in

considering use:

Ease of use/degree of simplicity required

Degree of accuracy required

Extent to which future cash flows can be measuredaccurately

Extent to which future interest rate movements can

be factored in and predicted

Necessity of factoring in effects of inflation

Absolutely vital

to alsoremember this for

evaluation!


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Extra exercises.

Invest 600k

Y1 = 100, Y2 = 400, Y3 = 400 Y4 = 180

Payback

ARR

Payback = 2 years & ??? Months Y3 400/12mths = 33.33 so need to repay

100 in 3rd year so in 2 years and 4 months


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Invest 600k

Y1 = 100, Y2 = 400, Y3 = 400 Y4 = 180

Payback = 2 years & ??? Months

Y3 400/12mths = 33.33 so need to repay100 in 3rd year so in 2 years and 4 months

ARR= 1080 600 = 480 / 4 years =120 /600 = 0.2 x 100 = 20%


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Homework

Read pages ?????

& make notes on advantages &

disadvantages of investmentappraisal methods.

02 investment appraisal 1

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