Accounts & Finance Investment Appraisal Learning Objectives To understand what investment means, why appraising investment projects is essential and the information needed for an investment appraisal Address why forecasting future cash flows adds uncertainty to investment appraisal Apply and analyse the payback method of investment appraisal Apply and analyse the average rate of return method of investment appraisal Analyse the importance of qualitative or non- numerical factors in many investment decisions Investing What is it? Investment means purchasing capital goods and improving existing fixed assets Investment represents a substantial risk, not only in losing money but also with regards to the opportunity cost of investment Opportunity Cost The cost of an alternative that must be foregone in order to pursue a certain action (the benefits you could have received) Opportunity Cost The cost of an alternative that must be foregone in order to pursue a certain action (the benefits you could have received) This term refers to the quantitative techniques used to calculate the financial costs and benefits of an investment decision There are 4 main methods of investment appraisal. The payback period The accounting rate of return (ARR) Discounted cash flows (HL only) Net present value (HL only) Investment appraisal? Quantitative Investment Appraisal Requires the following information Initial cost of the investment Estimated life expectancy Residual value (If the assets are sold at the end, what would be the net return?) Forecasted net returns or net cash flows Annual forecasted net cash flow Forecasted cash inflow forecasted cash outflow The amount of time it takes for an investment project to earn enough profit (net cash inflow) to repay the cost of the initial investment Payback period Finding the months The amount which is required (The difference between investment and the money you have before it goes over initial investment amount) / the entire year amount (The year which you will take the money from) * 12 The reason why we round the figure up is because if we took the lower figure, we would not have enough money to cover the payback. Advantages Quick & easy to do Useful information when planning if a company has cash flow problems. Will breakeven be reached by for a new produce needs replacing? If not is it worth investing in? Can compare different investments Disadvantages May encourage a short-termism approach to investment. Which investment breaks even soonest, not which one makes the most profit in the long-term. Contributions are rarely the same every month and could change. Focuses on time, not profit. Payback period Importance of payback of a project Can make comparisons with other projects Managers can check to see if they are able to pay back finance which may have been borrowed Measures the annual profitability of an investments as a percentage of the initial investment Average rate of return (ARR) Annual profit (net cash flow) Initial capital cost X 100 4 stages in calculating ARR 1.Add up all cash flows (except from year 0 which would be the initial investment) 2.Subtract the cost of investment 3.Divide by life span 4.Now do the ARR equation using your answer as the net return profit per annum YearNet cash flow 0($5 million) 1$2 million 2 3 4$3 million (including residual value) Use this method to work out the ARR YearNet cash flow 0($5 million) 1$2 million 2 3 4$3 million (including residual value) What does this show? Shows an expected 20% return on investment This can be then compared with ARR on other projects Criterion rate or level The minimum level (maximum for payback period) set by management for investment appraisal results for a project to be accepted ARR is shown as a percentage so that different projects of different sizes and for different amounts of time can be compared As a benchmark ARR can be compared with the base interest rate For example if ARR was 8% and interest rate was 5%, then the real rate of return is 3%. This level of ARR may be Ok for a larger multi-national company but a small business may expect significantly more Average rate of return (ARR) ARR