Investment Appraisal

A Level Business Studies

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The Nature Of Investment

Investment is when a business sacrifices current resources (assets) in order to enjoy a stream of benefits in the future in the form of increased revenues or cash inflows.

It involves expenditure today in order to produce revenue or an inflow of cash in the future.

Investment can either be:

1. Induced (rising sales)

2. Autonomous (replace old machinery)

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Types of Investment

Capital Goods. Goods purchased by businesses that aid in the production or manufacture of goods.

Machinery

Vehicles

Premises

Computer Hardware

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INVESTMENT APPRAISAL

DEFINITION:

Investment Appraisal is how a business decides if an investment project is worthwhile, or where alternatives exist, which option is likely to be the best.

Investment Appraisal involves several numerical techniques but also takes into account qualitative factors. The techniques include:

1. Payback

2. Average Rate of Return

3. Net Present Value (NPV)Clevedon Community School

PAYBACK PERIOD

This refers to the time it takes for an investment project to recover or payback the initial outlay (cost of investment).

It is preferred by small business because of its simplicity.

Large businesses may use it as a screening method before embarking on one the more complicated techniques.

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Example 1

PAYBACK PERIOD (when the cost of investment has been paid off)

4 YEARS

YEAR CASHFLOW (£) CUMULATIVE CASH FLOW (£)

0 (10,000) (10,000)

1 2,000 (8,000)

2 3,000 (5,000)

3 4,000 (1,000)

4 1,000 0

5 2,000 2,000

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EXAMPLE 2

YEAR MACHINE A MACHINE B

0 (10000) (10000)

1 3000 1000

2 5000 3000

3 3000 5000

4 2000 4000

5 3000 6000

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YEAR MACHINE A

0 (10000)

1 3000

2 5000

3 3000

4 2000

5 3000

CUMULATIVE CASH FLOW (£)

(10000)

(7000)

(2000)

1000

3000

6000

PAYBACK PERIOD IS BETWEEN 2 AND 3 YEARS

THEREFORE THE FOLLOWING CALCULATION IS USED.

INCOME REQUIRED X12

NET CASH FLOW FROM NEXT YEAR

INCOME REQUIRED =£2000

NET CASH FLOW FROM NEXT YEAR = 3000

MONTH OF PAYBACK =8 MONTHS

(2000/3000) X12

PAYBACK PERIOD =2 YEARS 8 MONTHS

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YEAR MACHINEB

0 (10000)

1 1000

2 3000

3 5000

4 4000

5 6000

CUMULATIVE CASH FLOW (£)

(10000)

(9000)

(6000)

(1000)

3000

9000

Now it’s your turn! Calculate the payback period for machine B

PAYBACK PERIOD =3 YEARS 3 MONTHS

= INCOME REQUIRED X12

NET CASH FLOW FROM NEXT YEAR

INCOME REQUIRED =£1000

NET CASH FLOW FROM NEXT YEAR =4000

MONTH OF PAYBACK =3 MONTHS

(1000/4000) X 12

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The payback period for machine A is 2 years 8 months

The payback period for machine B is 3 years 3 months

Therefore the business would select machine A

However machine B generates £6000 as opposed to £3000 by machine A. This is one of the disadvantages of this method. The advantages and disadvantages will now be examined.

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A Short Payback Period Can Be Useful When:-

When technology is changing rapidly. A business does not want to purchase an expensive piece of equipment and find that it is obsolete before it has been paid for. In certain circumstances innovations can carry with them cost and efficiency advantages that can give them the opportunity to increase their sales and market share.

Products can go out of favour with customers before they have brought in sufficient revenue to repay the costs of the investment. This is particularly true of high fashion products whose life may only be a few months before another product takes its place. It can also be true of technical products when innovation is moving rapidly.

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Advantages Payback

1. Simple to calculate.

2. Quick screening tool for analysis.

3. It places stress on early return, forecasts of which are likely to be more accurate.

4. An early return is especially important when liquidity is more important than profitability.

Disadvantages Payback1. It disregards all cash flows beyond the payback period so fails

to measure overall profitability.

2. It ignores the time value of money.

3. It discriminates against projects which involve a long payback period.

4. It fails to recognise that revenue generated early in the payback period is more valuable than money received later.