Investment Appraisal Methods

transcript

L3 Business Studies

InvestmentBuying the equipment needed to make or sell a product/service.

ISBuying

productive assets

IS NOTBuying shares, saving in the

bank or buying gold

Investment AppraisalDeciding on the best investment choice from a possible range.

involves CHOICE

What truck?

Investment AppraisalLearning

Objectives3 methods:

Payback Period

Accounting Rate of Return

Net Present Value

Investment is?Discuss with your partner and make your

choice. Write it in your notes.

APutting

money in an ASB account

BBuying

GOLD bars and storing

CBuying

productive assets

DInvesting in

XERO shares

Investment is?

APutting

money in an ASB account

BBuying

GOLD bars and storing

DInvesting in

XERO shares

CBuying

productive assets

Glass company wants to grow and needs a new delivery vehicle. It has decided on

3 possible options

HOW DOES IT MAKE A FINAL DECISION?

OPTION 1 OPTION 2 OPTION 3

DECISIONS, DECISIONS!

Investment Appraisal

3 methods:

Payback Period

Net Present Value

Payback periodHow long will it take to pay back the initial investment from NET CASH FLOWS

OPTION 1: $45000 initial investment

OPTION 2 $36000 initial investment

Payback period

NET CASH FLOWS are …Income received from asset minus costs of running

YOU WILL be given the NET CASH FLOW for each investment option in the exam.

Payback period

01 2 3 4 5OPTION 1:

$14000

Years (NET Cash Flow)$45000

$14000

$14000 $14000

$14000

Initial InvestmentAnnual Net Cash

Flows= PAYBACK PERIOD

If the annual flows are all the same …

Give it a go yourself

Payback period

01 2 3 4 5OPTION 1:

$14000

$14000 $14000

$14000

Payback period

01 2 3 4 5OPTION 2:

$10000

$9000 $9000 $12000

$12000

If the annual flows are different …

Give it a go yourself

Year Net Cash Flow

1 $,0002 $,000 $,0003 $,000 $,0004 $,000 $,000

Add each year until you have covered your investment

Payback period

01 2 3 4 5OPTION 2:

$10000

$9000 $9000 $12000

$12000

Payback period

01 2 3 4 5OPTION 3:

$18000

$22000

$26000 $26000

$30000

PAYBACK a little harder to find?YOUR TURN

3yrs 2 mthsB

2yrs 6 mthsC

3yrs 8mthsD

2yrs 10mths

Payback period

01 2 3 4 5OPTION 3:

$18000

$22000

$26000 $26000

$30000

PAYBACK a little harder to find?YOUR TURN

3yrs 2 mthsB

2yrs 6 mthsC

3yrs 8mthsD

2yrs 10mths

Payback period

01 2 3 4 5OPTION 3:

$18000

$22000

$26000 $26000

$30000

Year Net Cash Flow

1 $18,0002 $22,000 $40,0003 $26,000 $66,000

Need $60,00Add each year until you have covered your investment

Sometime in Yr2. Need extra 20,000 out of 26000 in Yr 3. 20,000/26,000= 0.769.0.769 x 12mths = 9.23 or 10 months approx.

PAYBACK = 2 years and 10 months

Payback period

WHICH PROJECT?

OPTION 1: 3yrs 3mths

OPTION 2 3yrs 8mths

OPTION 3 2yrs 10mths

Accept if:

1. Fastest PAYBACK – OPTION 3OR2. Meets criteria eg. PAYBACK < 3 yrs – OPTION 3

Payback period

What are the Criteria?

OPTION 1: 3yrs 3mths

OPTION 2 3yrs 8mths

OPTION 3 2yrs 10mths

Payback Period is?

AA method for paying off debts

approach to help decide on the best investment

CThe best form of

investment appraisal

DHow long it takes you to

pay for equipment

Payback Period is?

AA method for paying off debts

CThe best form of

DHow long it takes you to

pay for equipment

Payback period

WEAKNESSESThis method ignores:

1. The total return on the investment project (i.e. the earnings after payback).

2. The timing of the return (slow cash flows to start could result in rejecting profitable projects)

Investment Appraisal

3 methods:

Payback Period

Net Present Value

Average Rate of Return

aka Accounting Rate of ReturnTotal Return considered. Expressed as a %

OPTION 1: $45000 initial investment

01 2 3 4 5OPTION 1:

$14000

$14000 $14000

$14000

aka Accounting Rate of Return

Total Net Cash Flows from AssetExpected Life of

= Average Annual NCF

Initial Investment

Average Annual Net Cash Flows = Accounting

Rate of Return

Total net cash flows = Total inflows minus initial investment

Expected life of asset = Useful life of asset

01 2 3 4 5OPTION 1:

$14000

$14000 $14000

$14000

Total NCF = 70000 – investment 45000

35000/5 = 7000 7000/45000 = 15.5%

aka Accounting Rate of Return0

1 2 3 4 5OPTION 2:

$10000

$9000 $9000 $12000

$12000

Total Cash inflows = 52000 Life = 5 yrs

52000 – 36000 = 16000/5 = 3200

3200/36000 = 8.9%

1 2 3 4 5OPTION 3:

$18000

$22000

$26000 $26000

$30000

YOUR TURN

12.6%B

20.0%C

20.7%D

1 2 3 4 5OPTION 3:

$18000

$22000

$26000 $26000

$30000

YOUR TURN

12.6%B

20.0%D

18.3%C

1 2 3 4 5OPTION 3:

$18000

$22000

$26000 $26000

$30000

HOW?Total Cash Flows = 122000 Life = 5yrs

122000-60000= 62000/5 = 12400

12400/60000 = 20.7%

WHICH PROJECT?

OPTION 1: 15.5%

OPTION 2: 8.9%

OPTION 3: 20.7%

Accept if:

1. Best ARR– OPTION 3OR2. Meets criteria eg. ARR > 16% – OPTION 3

What are the Criteria?

aka Accounting Rate of ReturnOPTION 1: 15.5%OPTION 2: 8.9%OPTION 3: 20.7%

unsatisfactory interest

CThe best form of

Economic rate of return

unsatisfactory interest

CThe best form of

Economic rate of return

WEAKNESSESAttaches no importance to the timing of the inflows of cash. A.R.R treats all money as of equal value, irrespective of when it is received.

Hence, a project may be favoured even though it only produces a return over a long period of time.

More sophisticated methods take the timing and size of the cash inflows into account.

A sum of money in one year's time is worth less than that same sum of money now (i.e. inflation will erode the real value of that sum of money over the year).

This is where the notion of present value is used.

EXAM QUESTION

The new machinery will cost $730mExpected net cash flows per year;Year 1 194 Year 2 199 Year 3 207 Year 4 212 Year 5 217

EXAM QUESTIONThe new machinery will cost $730m

Expected net cash flows per year;Year 1 194 Year 2 199 Year 3 207 Year 4 212 Year 5 217

Net Present Value

An approach to investment appraisal that takes into

account the time value of money

Net Present Value

Sophisticated

Discounts Cash Flows

The value of future cash flows are discounted back to present day values.

A $dollar today is worth more than a $dollar received in the future.

Net Present Value

If I gave you $1 today you could invest it in the bank at current interest rates.

The same $1 in a years time has not been able to earn that interest so has less value to me in todays terms.

Net Present Value

Information you need to calculate:

Initial investmentAnnual cash flowsA % discounting rate (k)

Net Present ValuePresent value of net cash inflows minus initial investment

Cash Flow 1 (1 +

Cash Flow 2 (1 +

k)+ Cash Flow

3 (1 + k)

Cash Flow t (1 +

k)++2 3 t - Cash

Flow 0

NET PRESENT VALUE

Net Present ValueCash Flow 1 (1 +

Cash Flow 2 (1 +

k)+ Cash Flow

3 (1 + k)

Cash Flow t (1 +

k)++2 3 t - Cash

Flow 0

Cash Flow 2 (1 +

k)+ Cash Flow

3 (1 + k)

Cash Flow t (1 +

k)++2 3 t - Cash

Flow 0

01 2 3 4 5OPTION 1:

$14000

$14000 $14000

$14000

We will use a discount rate of 8% (.08).

You will be given this in the exam

Cash Flow 2 (1 +

k)+ Cash Flow

3 (1 + k)

Cash Flow t (1 +

k)++2 3 t - Cash

Flow 0

14000(1 + 0.08)

+ +2 3 - $45000(1 + 0.08)

14000 14000(1 + 0.08)

+ 4(1 + 0.08)

14000 + 514000(1 + 0.08)

12962.96 + 12002.74 + 11113.65 + 10290.42 + 9528.16 - 45000

$10897.93

Net Present Value

01 2 3 4 5OPTION 2:

$10000

$9000 $9000 $12000

$12000

Net Present Value

01 2 3 4 5OPTION 3:

$18000

$22000

$26000 $26000

$30000

YOUR TURN – closest to

$12600B

$20000C

$41000D

$36000

Net Present Value

01 2 3 4 5OPTION 3:

$18000

$22000

$26000 $26000

$30000

YOUR TURN – closest to

$12600B

$20000C

$41000D

$36000

Net Present Value

01 2 3 4 5OPTION 3:

$18000

$22000

$26000 $26000

$30000

Net Present Value

WHICH PROJECT?

OPTION 1: $10898

OPTION 2: $8058

OPTION 3: $35696

Net Present ValueDECISION CRITERIA?

OPTION 1: $10898

OPTION 2: $8058

OPTION 3: $35696

REJECT if NPV is less than zero

(reject none)

Net Present ValueDECISION CRITERIA?

OPTION 1: $10898

OPTION 2: $8058

OPTION 3: $35696

ACCEPT if NPV is positive(accept all)

Choose largest NPV

(Accept Option 3)

Payback Period

Net Present Value

Payback Period

Net Present Value

SIMPLEST SIMPLE SOPHISTICATE

Payback Period

Net Present Value

SIMPLEST SIMPLE SOPHISTICATE

Your Exam

Investment Appraisal Methods

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