Accounts & FinanceInvestment Appraisal

Learning ObjectivesTo 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 CostThe 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 flowForecasted 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 ARR1. Add up all cash flows (except from year 0 which would be

the initial investment)2. Subtract the cost of investment3. Divide by life span4. Now do the ARR equation using your answer as the net

return profit per annum

Year Net cash flow

0 ($5 million)

1 $2 million

2 $2 million

3 $2 million

4 $3 million (including residual value)

Use this method to work out the ARR

Year Net cash flow

0 ($5 million)

1 $2 million

2 $2 million

3 $2 million

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 projectsCriterion 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

Task