60
Investment Appraisal Methods L3 Business Studies
Investment Appraisal Methods
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
them
CBuying
productive assets
DInvesting in
XERO shares
Investment is?
APutting
money in an ASB account
BBuying
GOLD bars and storing
them
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
Accounting Rate of Return
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
OPTION 3 $60000 initial investment
Payback period
NET CASH FLOWS are …Income received from asset minus costs of running
asset
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
Years (NET Cash Flow)$45000
$14000
$14000 $14000
$14000
Payback period
01 2 3 4 5OPTION 2:
$10000
Years (NET Cash Flow)$36000
$9000 $9000 $12000
$12000
If the annual flows are different …
Give it a go yourself
Year Net Cash Flow
Total
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
Years (NET Cash Flow)$36000
$9000 $9000 $12000
$12000
Payback period
01 2 3 4 5OPTION 3:
$18000
Years (NET Cash Flow)$60000
$22000
$26000 $26000
$30000
PAYBACK a little harder to find?YOUR TURN
A
3yrs 2 mthsB
2yrs 6 mthsC
3yrs 8mthsD
2yrs 10mths
Payback period
01 2 3 4 5OPTION 3:
$18000
Years (NET Cash Flow)$60000
$22000
$26000 $26000
$30000
PAYBACK a little harder to find?YOUR TURN
A
3yrs 2 mthsB
2yrs 6 mthsC
3yrs 8mthsD
2yrs 10mths
Payback period
01 2 3 4 5OPTION 3:
$18000
Years (NET Cash Flow)$60000
$22000
$26000 $26000
$30000
Year Net Cash Flow
Total
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
BAn
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
investment appraisal
DHow long it takes you to
pay for equipment
BAn
approach to help decide on the best investment
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
Accounting Rate of Return
Net Present Value
Average Rate of Return
aka Accounting Rate of ReturnTotal Return considered. Expressed as a %
OPTION 1: $45000 initial investment
OPTION 2 $36000 initial investment
OPTION 3 $60000 initial investment
01 2 3 4 5OPTION 1:
$14000
Years (NET Cash Flow)$45000
$14000
$14000 $14000
$14000
Average Rate of Return
aka Accounting Rate of Return
Total Net Cash Flows from AssetExpected Life of
Asset
= 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
Years (NET Cash Flow)$45000
$14000
$14000 $14000
$14000
Total NCF = 70000 – investment 45000
35000/5 = 7000 7000/45000 = 15.5%
Average Rate of Return
aka Accounting Rate of Return
Average Rate of Return
aka Accounting Rate of Return0
1 2 3 4 5OPTION 2:
$10000
Years (NET Cash Flow)$36000
$9000 $9000 $12000
$12000
Total Cash inflows = 52000 Life = 5 yrs
52000 – 36000 = 16000/5 = 3200
3200/36000 = 8.9%
Average Rate of Return
aka Accounting Rate of Return0
1 2 3 4 5OPTION 3:
$18000
Years (NET Cash Flow)$60000
$22000
$26000 $26000
$30000
YOUR TURN
A
12.6%B
20.0%C
20.7%D
18.3%
Average Rate of Return
aka Accounting Rate of Return0
1 2 3 4 5OPTION 3:
$18000
Years (NET Cash Flow)$60000
$22000
$26000 $26000
$30000
YOUR TURN
A
12.6%B
20.0%D
18.3%C
20.7%
Average Rate of Return
aka Accounting Rate of Return0
1 2 3 4 5OPTION 3:
$18000
Years (NET Cash Flow)$60000
$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%
Average Rate of Return
aka Accounting Rate of Return
Accept if:
1. Best ARR– OPTION 3OR2. Meets criteria eg. ARR > 16% – OPTION 3
What are the Criteria?
Average Rate of Return
aka Accounting Rate of ReturnOPTION 1: 15.5%OPTION 2: 8.9%OPTION 3: 20.7%
AAn
unsatisfactory interest
rate
BAn
approach to help decide on the best investment
CThe best form of
investment appraisal
Daka
Economic rate of return
Average Rate of Return
aka Accounting Rate of Return
Average Rate of Return
aka Accounting Rate of Return
AAn
unsatisfactory interest
rate
CThe best form of
investment appraisal
Daka
Economic rate of return
BAn
approach to help decide on the best investment
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.
.
Average Rate of Return
aka Accounting Rate of Return
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.
.
Average Rate of Return
aka Accounting Rate of Return
EXAM QUESTION
EXAM QUESTION
EXAM QUESTION
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
Net Present ValuePresent value of net cash inflows minus initial investment
Cash Flow 1 (1 +
k)
=
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 +
k)
Cash Flow 2 (1 +
k)+ Cash Flow
3 (1 + k)
Cash Flow t (1 +
k)++2 3 t - Cash
Flow 0
Net Present ValueCash Flow 1 (1 +
k)
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
Years (NET Cash Flow)$45000
$14000
$14000 $14000
$14000
We will use a discount rate of 8% (.08).
You will be given this in the exam
Net Present ValueCash Flow 1 (1 +
k)
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
Years (NET Cash Flow)$36000
$9000 $9000 $12000
$12000
Net Present Value
01 2 3 4 5OPTION 3:
$18000
Years (NET Cash Flow)$60000
$22000
$26000 $26000
$30000
YOUR TURN – closest to
A
$12600B
$20000C
$41000D
$36000
Net Present Value
01 2 3 4 5OPTION 3:
$18000
Years (NET Cash Flow)$60000
$22000
$26000 $26000
$30000
YOUR TURN – closest to
A
$12600B
$20000C
$41000D
$36000
Net Present Value
01 2 3 4 5OPTION 3:
$18000
Years (NET Cash Flow)$60000
$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)
Investment AppraisalLearning
Objectives3 methods:
Payback Period
Accounting Rate of Return
Net Present Value
Investment AppraisalLearning
Objectives3 methods:
Payback Period
Accounting Rate of Return
Net Present Value
SIMPLEST SIMPLE SOPHISTICATE
D
Investment AppraisalLearning
Objectives3 methods:
Payback Period
Accounting Rate of Return
Net Present Value
SIMPLEST SIMPLE SOPHISTICATE
D
Your Exam
s
