IB Business and Management

3.2 Investment Appraisal

Learning Outcomes

• Calculate Payback Period and ARR for an Investment

• Analyse the results of calculations• Calculate the NPV for an investment (HL)• Analyse the results of the calculations (HL)

Definition

Investment appraisal is the process of businesses evaluating whether an investment is attractive

Or, where alternatives exist, which option is likely to be the best.

Investments:• tie up the firm’s finance

for a long period, normally for a number of years;

• generate financial benefits (profits) over most or all of their useful life;

• often have a resale or scrap value at the end of their life.

• Because of the major capital outlays involved, managers try to calculate expected profitability/ cash flows for the proposed investment.

BEFORE WE START LOOKING AT TECHNIQUES……. CONSIDER THE FOLLOWING INVESTMENT DECISION

Which investment should be chosen?

Investment AInvestment A Investment BInvestment B Investment CInvestment C

Initial CostInitial Cost £70,000£70,000 £100,000£100,000 £200,000£200,000

Estimated Profit Estimated Profit GeneratedGenerated

Year 1Year 1 £10,000£10,000 £50,000£50,000 £20,000£20,000

Year 2Year 2 £10,000£10,000 £40,000£40,000 £30,000£30,000

Year 3Year 3 £20,000£20,000 £40,000£40,000 £30,000£30,000

Year 4Year 4 £20,000£20,000 £30,000£30,000 £60,000£60,000

Year 5Year 5 £30,000£30,000 £100,000£100,000

Year 6Year 6 £40,000£40,000 £100,000£100,000

Quantitative Techniques

• Payback

• Average Rate of Return (ARR)

• Net Present Value (NPV)

PAYBACK PERIOD

Payback

• This method of investment appraisal calculates how long it takes a project to repay its original investment.

• The shorter the payback period, the more faourable the investment

• It highlights investments which pay back the initial investment the quickest

Payback – Which Investment should be chosen?

Investment AInvestment A Investment BInvestment B Investment CInvestment C

Initial CostInitial Cost £70,000£70,000 £70,000£70,000 £70,000£70,000

Estimated Profit Estimated Profit GeneratedGenerated

Year 1Year 1 £10,000£10,000 £20,000£20,000 £30,000£30,000

Year 2Year 2 £10,000£10,000 £20,000£20,000 £30,000£30,000

Year 3Year 3 £20,000£20,000 £20,000£20,000 £20,000£20,000

Year 4Year 4 £20,000£20,000 £20,000£20,000 £10,000£10,000

Year 5Year 5 £30,000£30,000 £20,000£20,000 £10,000£10,000

Year 6Year 6 £40,000£40,000 £20,000£20,000 £10,000£10,000

TotalTotal £130,000£130,000 £120,000£120,000 £110,000£110,000

Results

• Investment C would be chosen because it has the shortest payback time, i.e. slightly less than three years.

• Investment A’s payback stretches into the fifth year and Investment B’s into the fourth.

Note that total income is not taken into account in this method. In fact Project C has the lowest total return over the 6 years.

Calculating the exact pay back period

Investment AInvestment A

Initial CostInitial Cost £70,000£70,000

Estimated Profit Estimated Profit GeneratedGenerated

Year 1Year 1 £10,000£10,000

Year 2Year 2 £10,000£10,000

Year 3Year 3 £20,000£20,000

Year 4Year 4 £20,000£20,000

Year 5Year 5 £30,000£30,000

Year 6Year 6 £40,000£40,000

TotalTotal £130,000£130,000

In order to make back the £70,000£70,000Investment we need:

-All of the profits from years 1-4-Plus £10,000 of the £30,000 £10,000 of the £30,000 generated in year 5generated in year 5

-The payback period is therefore 4 The payback period is therefore 4 years plus 10,000/30,000 years plus 10,000/30,000

In DaysIn Days10,000/30,000 X 365 = 10,000/30,000 X 365 =

In WeeksIn Weeks10,000/30,000 X 52 = 10,000/30,000 X 52 =

In MonthsIn Months10,000/30,000 X 12= 10,000/30,000 X 12=

Question

Project AProject A Project BProject B

Initial CostInitial Cost £8,000£8,000 £6,000£6,000

IncomeIncome

Year 1Year 1 £3,000£3,000 £5,000£5,000

Year 2Year 2 £5,000£5,000 £4,000£4,000

Year 3Year 3 £9,000£9,000 £6,000£6,000

TotalTotal £17,000£17,000 £15,000£15,000

Which project should the company choose fi payback period is being used?

Answer

• Both projects have the same return over 3 years.• Project A has a payback of 2 years• Project B has a payback of 1 year 3 months• Therefore Project has the shortest payback time

and should be chosen

AVERAGE RATE OF RETURN

ARR- Average Rate of Return

• The ARR method measures the net return each year as a percentage of the initial cost of the investment.

The formula for ARR is:

Average Annual Profit X 100 Initial Outlay

ExampleProject XProject X Project YProject Y Project ZProject Z

CostCost £50,000£50,000 £40,000£40,000 £90,000£90,000

Return:Return:

Year 1Year 1 £10,000£10,000 £10,000£10,000 £20,000£20,000

Year 2Year 2 £10,000£10,000 £10,000£10,000 £20,000£20,000

Year 3Year 3 £10,000£10,000 £20,000£20,000 £30,000£30,000

Year 4Year 4 £20,000£20,000 £20,000£20,000 £30,000£30,000

Year 5Year 5 £20,000£20,000 £30,000£30,000

Step 1- Calculate Total Net Profit

This is total profits over the life time of the investment with the initial investment deducted

£70,000 - £50,000 = £20,000 for Project X.

Step 2 – Calculate Annual Profit

The next step is to calculate the net profit per annum by dividing the total net profit by the number of years the project runs for

•£20,000 5 = £4,000 for Project X.

Step 3 – Calculate the ARR

Average Annual Profit X 100 Initial Outlay

For Project X £4,000 x 100 = 8%£50,000

Overall Results – Calculate the ARR for Project Y and Project Z

Project XProject X Project YProject Y Project ZProject Z

Initial CostInitial Cost £50,000£50,000

Total Net Total Net ProfitProfit

£20,000£20,000

Net Profit Net Profit per Annumper Annum

£4,000£4,000

ARRARR 8%8%

Overall Results…Which Project should be

chosen?Project XProject X Project YProject Y Project ZProject Z

Initial CostInitial Cost £50,000£50,000 £40,000£40,000 £90,000£90,000

Total Net Total Net ProfitProfit

£20,000£20,000 £20,000£20,000 £40,000£40,000

Net Profit Net Profit per Annumper Annum

£4,000£4,000 £5,000£5,000 £8,000£8,000

ARRARR 8%8% 12.5 %12.5 % 8.9%8.9%

Come back to this decision from the start of the lesson

Investment AInvestment A Investment BInvestment B Investment CInvestment C

Initial CostInitial Cost £70,000£70,000 £100,000£100,000 £200,000£200,000

Estimated Profit Estimated Profit GeneratedGenerated

Year 1Year 1 £10,000£10,000 £50,000£50,000 £20,000£20,000

Year 2Year 2 £10,000£10,000 £40,000£40,000 £30,000£30,000

Year 3Year 3 £20,000£20,000 £40,000£40,000 £30,000£30,000

Year 4Year 4 £20,000£20,000 £30,000£30,000 £60,000£60,000

Year 5Year 5 £30,000£30,000 £100,000£100,000

Year 6Year 6 £40,000£40,000 £100,000£100,000

Calculate the Payback and ARR for each of these Investments. Which one do you think should be chosen? Why?

Task – Practice Questions

• Answer the questions:

• Payback and ARR Quick Questions• Pilgrims Choice (Payback and ARR)

NET PRESENT VALUEThe Higher Level Stuff

Money now is more valuable than money later on……

Why?

Present Values

So $1,000 now is the same as $1,100 next year (at 10% interest)

We say the Present Value of $1,100 next year is $1,000

And on and on……

So…. Businesses might find it useful to know the Present Values of future profits they expect to make

Example

Investment A promises you $90,0 00 in 3 years, what is the Present Value?•To take a future payment backwards three years divide by 1.10 three times•So $90,000 in 3 years is:•$90,000 ÷ 1.10 ÷ 1.10 ÷ 1.10 •$90,000 ÷ (1.10 × 1.10 × 1.10) = 1.103

•$90,000 ÷ 1.331•$67,618 now

Question: What would the difference be if only a 5% interest rate was assumed?

Net Present Value

• NPV is a method of investment appraisal that take the present value of future profits/cashflows into account rather than the nominal value

• It therefore favours investments that bring in profits/cashflows more immediately

• It considers overall profitability of investments at present values

Making decisions using NPV

Normally the project with the highest NPV will be chosen.

• If the NPV is positive - cash benefits exceed cash costs - this means that the project will earn a return in excess of its cost of capital (the rate of interest/discounting used in the calculation).

• If the NPV is negative - this tells the managers that the cost of investing in the project exceeds the present value of future receipts, and that it is not worth investing in it.

Example Question

YearYear Project AProject A Project BProject B

00 -250-250 -250-250

11 +50+50 +200+200

22 +100+100 +100+100

33 +200+200 +50+50

Assuming that the interest rate is 10%, calculate the NPV of both projects and decide which one would be the better investment

Use the discount table

Example Answers(Assuming an interest rate of 10%)

Project A

Returns Discount Factor

Year 0 -£250

Year 1 +£50

Year 2 +£100

Year 3 +£200

1.00

0.91

0.83

0.75 £150

£83

£45.50

-£250

Present Value

Net Present Value = £28.50

Example Answers(Assuming an interest rate of 10%)

Project B

Returns Discount Factor

Year 0 -£250

Year 1 +200

Year 2 +£100

Year 3 +£50

1.00

0.91

0.83

0.75 £37.50

£83

£182

-£250

Present Value

Net Present Value = £52.50

Question (All values in £)

YearYear Investment AInvestment A Investment BInvestment B

00 -800-800 -500-500

11 300300 100100

22 300300 150150

33 300300 250250

44 300300 250250

55 300300 300300

Calculate the Net Present Value for these two investments assuming a discount factor of 8%

Answers

YearYear Investment Investment AA

Discount Discount FactorFactor

Present Present ValueValue

00 -800-800 1.001.00 -800-800

11 300300 0.890.89 267267

22 300300 0.800.80 240240

33 300300 0.710.71 213213

44 300300 0.640.64 192192

55 300300 0.570.57 171171

NPV=NPV= 283283

Answers

YearYear Investment Investment BB

Discount Discount FactorFactor

Present Present ValueValue

00 -500-500 1.001.00 -500-500

11 100100 0.890.89 8989

22 150150 0.800.80 120120

33 250250 0.710.71 177.50177.50

44 250250 0.640.64 160160

55 300300 0.570.57 171171

NPV=NPV= 217.50217.50

Interpretation

• Purely based on NPV Investment A should be chosen with a return of £283 against a return of £217.50 for investment B

• However if we look at the return as a % of the initial investment Project A = 35% whereas Project B = 44%.

• The company may wish to look at non-financial factors to help them make the decision

Task - Questions

• Answer the questions:

• NPV Quick Questions• Pilgrims Choice (NPV)

EVALUATING EACH METHOD….

Task

• Each group take one method of Investment Appraisal.

• Try to come up with your own list of advantages and disadvantages of each method.

• Payback• ARR• NPV

Payback PeriodAdvantages and Disadvantages

Advantages• it is easy to calculate

and understand• its use emphasises

liquidity, because the calculations are based exclusively on cash flows

• it helps managers to reduce risk by selecting the project which recovers its outlay most quickly

Limitations• cash earned after the

‘payback’ is not taken into account in the decision to invest

• it completely ignores the potential profits that can be earned since the criterion is the speed of repayment

• Short-termism• Doesn’t take into

consideration decreasing value of money

Average Rate of ReturnAdvantages and Limitations

Advantages• it is simple to calculate

and understand• it shows clearly the

profitability of an investment project

• it allows a better comparison of alternative projects, because it is related to the size of the initial investment outlay

• Can be directly compared to bank interest rates

Limitations• it disregards the fact

that money received at a later date does not possess the same real value as money received today

Net Present ValueAdvantages and Limitations

Advantages• Net Present Value

takes into account that interest rates affect the present value of future income.

• future cashflows are discounted by a ‘discount factor’ that the firm decides on and is affected by the rate of interest

Limitations• It is time consuming

and more difficult to calculate than payback and ARR

• Choosing the right discount factor can be difficult

QUALITATIVE FACTORSWhat else should be taken into account?

Introduction

• Investment Appraisal provides a scientific decision-making technique for managers

• However financial data do not always show the full picture, so a firm must not base its decisions solely on investment appraisal results.

• Other factors to be considered, and their relative importance will vary according to circumstances

Key Qualitative Factors

• The aims of the organisation• Liquidity position• Reliability of data• Production Requirements• Personnel• The economy• Image/public relations• Subjective factors

Timed IB Question – 18 minutes

• Answer the Altair Incorporated question

(SL students only have to do ARR and Payback. Q1 will only be worth 5 marks and only 13 minutes will be given)

Discount Table

Years Years AheadAhead

6%6% 8%8% 10%10% 12%12% 15%15%

00 1.001.00 1.001.00 1.001.00 1.001.00 1.001.00

11 0.940.94 0.930.93 0.910.91 0.890.89 0.870.87

22 0.890.89 0.860.86 0.830.83 0.800.80 0.760.76

33 0.840.84 0.790.79 0.750.75 0.710.71 0.660.66

44 0.790.79 0.740.74 0.680.68 0.640.64 0.570.57

55 0.750.75 0.680.68 0.620.62 0.570.57 0.500.50