1 / 51

Investment Appraisal Unit 3.8

Investment Appraisal Unit 3.8. When considering a major purchase a firm will take into account:. The initial cost Future benefits e.g. revenues, residual value Future costs e.g. interest payments, depreciation Alternatives e.g. other projects and uses of funds

riverah
Download Presentation

Investment Appraisal Unit 3.8

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Investment Appraisal Unit 3.8

  2. When considering a major purchase a firm will take into account: • The initial cost • Future benefits e.g. revenues, residual value • Future costs e.g. interest payments, depreciation • Alternatives e.g. other projects and uses of funds • The degree of risk - which will vary with the economic climate

  3. Investment appraisal looks at how to answer the question 'is it worth investing in that project?’ • Investment appraisal refers to the quantitative techniques used to calculate the financial costs and benefits of an investment decision. • The methods used require two main pieces of information • The capital cost of the project • The value of the project (what cash will it bring in for the cost?)

  4. Investment appraisal is a forward-looking process. It considers what might happen, and makes forecasts. These are then used to make calculations and analyses. However, these forecasts will always contain elements of inaccuracy, uncertainty and risk and we learn in these sections also how to take account of this.

  5. Investment appraisal is built around estimates of future cash flows - cash flow into and out of the company as a result of a particular investment project. • These are almost certainly not entirely accurate. The capital cost will not really be known until it is actually done. Plus or minus 5% would be a good level of accuracy from a good, experienced project team. Cash inflows are also notoriously hard to predict with any accuracy.

  6. Cash Outflow • This is all the costs of the project. It will be built up by the 'Projects Department', probably by engineers. It may be built up of a series of sub-estimates that are all put together to get the overall cost.

  7. Cash Inflow • This is the estimate of the value of the project. It is expressed in terms of net cash inflow.

  8. Net Cash Flow • The cash the project will bring in, (sales revenue) less annual costs incurred in the manufacture and sale of the product. • The heart of the forecast of net cash inflow is the sales forecast produced by the marketing department. This may possibly be inaccurate as it is a forecast. This inaccuracy may be magnified if there are also problems with the cost side of net cash inflow.

  9. Net Cash Flow • Notice that a cash flow forecast is not a profit forecast. We are concerned with real money here. • Cash inflows often tend to be overestimated. Who has ever come across a pessimistic brand manager? Marketing people tend to be optimists - the product will sell well - so the sales forecast will probably be an overestimate of the real situation.

  10. Reasons for inaccuracy are: • Firms do not work in a vacuum. They cannot predict accurately the actions of the competition, the development of the market, changes in consumer taste, and changes in the economy and government regulation. • Firms cannot predict the prices of materials, or the cost of laborin advance. • Some items cannot be predicted in advance. • The weather may be very unseasonable and cause sales to be different to the forecast. Thus there is a considerable element of risk when these figures are used.

  11. It is important when considering the results of investment appraisal operations to be aware of the source and the quality of the data involved. An allowance should be made for the risk element.

  12. Investment appraisal techniques • Firms have to decide if they should invest in projects or not. They have to make choices between projects, or decide if they should stay as they are. This is the area of investment appraisal, the process which gives help and assistance in decision making situations.

  13. The basic requirements of investment appraisal are: • An estimate of what the project will cost. This is the capital investment. • An estimate of what the project will earn the firm. This is called the forecast of net cash inflow.

  14. Investment appraisal methods divide into two groups: • Simple, easy to calculate methods. They are not very accurate or sensitive, but are good for screening out poor projects from a long list. All projects should be subjected to these tests. These screening tests are • Payback period • Average rate of return (ARR)

  15. Investment appraisal methods divide into two groups: • If a project passes through the first screening, then it is subjected to the next set of detailed, accurate tests. These complex tests are based on discounted cash flow methods. The main tests are • Discounted cash flow (DCF) * • Net present value (NPV)* *HL only

  16. Payback Period (PBP) • Refers to the amount of time needed for an investment project to earn enough profits to repay the initial cost of the investment. Formula: Initial investment cost Contribution per month

  17. Page 306 – 307 Examples

  18. EXAM TIP! • Students often conclude that because something is ‘high risk’ or ‘risky’, a business should avoid it. This is not reflective of the real business world where entrepreneurs have to regularly make decisions that involve an element of risk. Many businesses have become highly successful by taking huge risks. The decision is not whether to take risks but whether the benefits of the risk are likely to outweigh the costs involved.

  19. 'Payback'

  20. Payback Period (Investopedia) • http://www.investopedia.com/terms/p/paybackperiod.asp

  21. A newspaper considering the purchase of a new printing machine is faced with the choice between ‘The Printswell’ and ‘The Hotpress’ both initially costing £120,000

  22. Payback is the time it takes to recover the original investment cost Steps: • Calculate the cumulative net annual return • The payback year is when the cumulative return equals the capital outlay • To calculate the number of days in the payback year, divide the amount required to complete the payback by the return in that year and multiply by 365 The Printswell = 3 years 122 days (since 20/60 x 365 = 122) The Hotpress = 2 years 91 days (since 10/40 x 365 = 91)

  23. Advantages easy to calculate provides a useful measure of risk (Hotpress is a safer bet) the shortest payback is useful where: technology or consumer tastes change rapidly (helps to avoid assets becoming obsolete) funds are limited - helps reduce indebtedness & cashflow problems Disadvantages ignores timing of returns ignores all net returns after the payback date takes no account of the long-term profitability of a project

  24. 'Average Rate of Return'

  25. Average Rate of Return (Investopedia) • http://www.investopedia.com/terms/a/arr.asp

  26. ARR • This is a measure of profit, and it is in the familiar percentage form. It has its attractions to some people, as it is quite a straightforward measure of return. The average rate of return looks at the average net gain made per year, expressed as a percentage of the initial investment. • Formula: (Total profit during project’s lifespan divided by # of years of project) / Initial amount invested x 100

  27. The average profit generated per year by a project is expressed as a % of the initial amount invested and the highest ARR is chosen ARR = average return per year/ initial amt invested x 100 Steps: • add up the annual returns (or cash inflow) • deduct the initial cost (to get the overall profit) • divide by the number of useful years (to get the average return per year) • divide this figure by the initial cost and x 100 (to get the ARR) The Printswell = 16.7% The Hotpress = 13.3%

  28. Advantages takes account of returns over the whole life of a project provides a comparison with the returns available on alternative uses of funds Disadvantages ignores the timing of returns e.g. a project with high returns in the early years may be more preferable to one that is more profitable overall Ignores the effect of inflation on the value of money over time

  29. Practice • Project X Project Y Project Z • Cost £50,000 £40,000 £90,000 • Return Yr 1 £10,000 £10,000 £20,000 • Yr 2 £10,000 £10,000 £20,000 • Yr 3 £15,000 £10,000 £30,000 • Yr 4 £15,000 £15,000 £30,000 • Yr 5 £20,000 £15,000 £30,000 • Total £70,000 £60,000 £130,000 • Steps to calculate the ARR: • Calculate the profit from each project (total return – cost). • Calculate the average profit per year (total profit ÷ No of years). • Calculate ARR.

  30. SOLUTION • Project X Project Y Project Z • Cost £50,000 £40,000 £90,000 • Total Profit £20,000 £20,000 £40,000 • Profit £4,000 £4,000 £8,000 • per year • ARR 8% 10% 8.9%

  31. Exam tipPage 309

  32. Question 3.8.2PBP and ARR

  33. 'Net Present Value'

  34. Net Present Value • http://www.investopedia.com/terms/n/npv.asp

  35. Steps: • start by calculating the value today of future returns e.g. if interest rates are 10% then £110 received after one year is really worth £100 today • to do this future expected net returns are ‘discounted’ using a discount factor based on the rate of interest • Use the following discount factors to find the present value of the expected future returns for the Printswell and Hotpress: Simply multiply the net return in each year by its discount factor, add up your results and deduct the capital outlay

  36. the initial outlay is then deducted from the discounted cash flows to arrive at the investments Net Present Value The Printswell (£000) = 27.27 + 24.78 + 30.04 + 40.98 + 31.05 + 16.92 less 120 = 51.01 The Hotpress (£000) = 54.54 + 41.03 +30.04 + 24.59 + 12.42 + 5.64 less 120 = 48.53 • a project is viable if the NPV is positive • the project with the highest NPV is chosen

  37. See Exam TipPage 311

  38. EXAM TIP! • All students are expected to be able to calculate the Payback Period and ARR from given data. HL students also need to learn to calculate and interpret the NPV. More importantly, as this is not an accounts or finance examination, you are expected to be able to analyze the results of their calculations and explain the implications for business decision-making. From time to time, students will be asked directly to use a method of investment appraisal. Students may be asked to calculate the payback period, ARR and NPV (to 2 decimal places). You might also be asked to evaluate specified investment options and to recommend which investment option to pursue.

  39. COMMON MISTAKE • Make sure you use the correct units of measurement for the different methods of quantitative investment appraisal as marks are often lost for making careless mistakes. • The PBP is measured by time (e.g. 2 years and 5 months) • ARR is expressed as a percentage (e.g. 12.6%) • NPV is stated as a monetary value (e.g. $3.65 million)

  40. So, with all of the problems associated with these methods of analysis, what are they used for? • They are simple and quick to prepare, and are used as screens to weed out poor, or useless, projects. • Firms have to set themselves 'action standards' for payback and ARR, say 3 years maximum and 15% minimum, and only if these are met and/or exceeded will a project 'pass' to be examined by the more complex discounted cash flow method. • Action standards are selected by the firm concerned to reflect their view of the future and individual requirements.

  41. To what extent are quantitative investment appraisal methods useful when choosing between investment projects?

  42. Limitations of Investment Appraisal: • relies on forecasts which may prove to be highly inaccurate • only considers quantitative factors - takes no account of qualitative factors such as staff attitudes to a project • takes account of internal or ‘private’ costs and ignores any external costs i.e.‘social costs such as pollution

  43. Key TermsReview

  44. Average Rate of Return (ARR) • Calculates the average annual profit of an investment project, expressed as a percentage of the initial sum of money invested.

  45. Investment • Refers to the purchase of assets with the potential to yield future financial benefits, e.g. upgrading computer systems or the purchase of property (such as land and buildings).

  46. Investment Appraisal • Is a financial decision-making tool that helps managers to calculate whether certain investment projects should be undertaken based mainly on quantitative techniques.

  47. Payback Period (PBP) • Is an investment appraisal technique that calculates the length of time needed to recoup (earn back) the initial expenditure on an investment project.

  48. Qualitative investment appraisal • Refers to judging whether an investment project is worthwhile through non-numerical means, e.g. is the investment consistent with the corporate culture.

  49. Quantitative investment appraisal • Refers to judging whether an investment project is worthwhile based on numerical (financial) interpretations, ie. the PBP, ARR and NPV.

  50. Discounted Cash Flow (HL) • Uses a discount factor (the inverse of compound interest) to reduce the value of money received in future years because money loses its value over time.

More Related