3.3.2 Investment Appraisal

🔗 Investment refers to the purchase of capital goods, plus expenditure on research and the development of new products.

🔗 Investment appraisal is the evaluation of an investment project to determine whether or not it is likely to be worthwhile.

There are Three Main Methods

• Payback period (also known as simple payback)
• Average rate of return (also known as average accounting rate of return) – ARR
• Net present value (also known as discounted cashflow) – NPV

Payback

• Refers to the amount of time it takes for a project to recover or 'payback' the initial investment.
• It relies on the net cash flow figure (current assets – current liabilities).
• It is calculated through the cumulative net cash flow

$$Payback in months = Amount required / net cash flow (for that year) x 12$$

📝 E.G

	Y0	Y1	Y2	Y3	Y4	Y5
Net cash flow	(500)	100	125	125	150	150
Accumulative net cash flow	(500)	(400)	(275)	(150)	0	150

📝 E.G

Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Total net cash flow
(70)	10	10	20	20	30	40	60
(70)	(60)	(50)	(30)	(10)	20	60	-------------

Year 4: £10,000 from covering initial investment

Year 5: Investment is covered

10,000 (amount required)

$$------------- x 12 = 4 months$$

30,000 (net cash flow of the following year)

4 months into the 5th year, therefore Payback Period = 4 years, 4 months

Pros and Cons of the Payback Period

• Simple to use
• Good for businesses who struggle with cash flow (can plan outflows and inflows accordingly)
• Does not look at overall project return after investment has been covered
• Takes no account of the time value of money (E.G inflation)
• Ignores qualitative aspects of decision making (E.G worker motivation)

Average Rate of Return (ARR)

🔗 Investment – Money spent on capital goods.

🔗 Investment appraisal – The evaluation of an investment project to determine whether or not it is likely to be worthwhile

🔗 Average rate of return (ARR) – A method that measures the net return per annum as a percentage of the initial investment

Formula

$$ARR = (Net return per year/initial investment) x 100$$

Capital cost	£-50,000
Year 1	£10,000
Year 2	£10,000
Year 3	£15,000
Year 4	£15,000
Year 5	£20,000
Total net cash flow	£70,000

• Net cash flow: 70,000 – 50,000 = £20,000
• Net return per annum: 20,000/5 = £4,000
• 4000 (net return per annum)

$$------------- x 100 = 8$$

• 50,000 (cost of investment)

Pros and Cons of ARR

• Can easily compare a range of project options.
• Can easily identify the investment potential of a project to that of a savings account. Identifies the opportunity cost
• It takes no account of the length of the project.
• Ignores the time value of money (E.G Exchange rate, inflation).

Net Present Value (NPM)

🔗 NPV – The monetary value now of the project's future cash flows.

• Uses a discounted cash flow to calculate the net income for the project using discount factors.
• Each year's discounted figure is added up and compared to the initial investment.
• A positive NPV is always good. 📝 Example

Year	Discount (reduction in value)
0	1
1	0.91
2	0.84

A company wants to buy net machinery for £100,000 the equipment has an expected life of 2 years. The company expects to generate revenue of £70,000 per year with the new equipment.

$$(70,000 x 0.91) + (70,000 x 0.84) = £122,500$$ $$100,000 + 122,500 = £22,500$$

Pros and Cons of NPM

• Discount takes economic factors into account.
• Can be changed to suit market conditions.
• Forecasts are based on assumptions.
• Does not take freak occurrences or external shocks into account.
• Not easily comparable with different-sized investments.