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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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Investment Appraisal
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
Investment Appraisal
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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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Investment Appraisal
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.