Philip Allan Publishers © 2015

Investment appraisal

The basics

Philip Allan Publishers © 2015

Investment appraisal

There are three different tools a business can use to assess the merits of different investments:• payback period• average rate of return• net present value

Philip Allan Publishers © 2015

Payback periodThis is the amount of time it takes to recoup the cash outlay of the investment, e.g.

The example above shows that option 1 pays back after 2 years as the £20,000 is

recovered after two £10,000 cash inflows. However, option 2 is somewhere between

years 2 and 3, so we use the following formula: 

Amount required 10,000

--------------------- × 12 --------------------------- × 12 = 2 years 6 months

Amount received 20,000

  Option 1 Option 2

Capital outlay (£) (20,000) (40,000)

Net income year 1 (£) 10.000 10,000

Net income year 2 (£) 10,000 20,000

Net income year 3 (£) 10,000 20,000

Net income year 4 (£) 10,000 40,000

Net income year 5 (£) 10,000 40,000

Average rate of return (1)

This is a more meaningful and complex method of investment appraisal. It works out a % return for each investment and is a much more useful comparison to other tools such as ROCE.

There are four simple steps:

1. Work out the total return of the project.

2. Subtract the cost of the project. This gives the net return.

3. Divide by the number of years. This gives the net return per annum.

4. Divide the net return per annum by the cost of the project and multiply by 100 (see worked example).

Average rate of return (2)

Worked example

Cost: (£100,000)

Year 1: £50,000

Year 2: £50,000

Year 3: £50,000

Year 4: £150,000

Year 5: £150,000

Step 1: add up all cash flows = £450,000

Step 2: deduct outlay = £450,000 – £100,000 = £350,000

Step 3: divide by number of years = £350,000/5 = £70,000

Step 4: divide by outlay = £70,000/£100,000 and multiply by 100 = 70% return

Average rate of return (3)

Advantages Uses all the cash flows over the project’s life. Focuses on profitability, unlike payback. Easy to compare.

 

Disadvantages Ignores the timing of the cash flows (unlike NPV). As later years included it could be argued to be less accurate than

payback. It’s only a forecast (can be very unpredictable).

Net present value (1)

If £100 now is worth £110 in a year’s time, it would be good to know how much £100 in a year’s time is worth today.

This method of investment appraisal takes into consideration the current value of the project to see whether it is worthwhile.

Net present value (NPV) calculates the present value of all the money coming into a business.

It uses something called a discount factor, which is basically an interest rate in reverse, e.g. £10,000 in 1 year’s time is worth £9,909 now.

In other words £9,909 invested now would be £10,000 in a year’s time.

Net present value (2)

Worked example

Outlay: (£40,000)

Year 1: £10,000 × 0.91 = 9,100

Year 2: £10,000 × 0.83 = 8,300

Year 3: £10,000 × 0.75 = 7,500

Year 4: £10,000 × 0.68 = 6,800

Year 5: £10,000 × 0.62 = 6,200

I.e. year 1 cash flow is £10,000 but NPV theory tries to calculate the present

value of that inflow, which is £9,100

With NPV applied, the total cash flows are £37,900 in present value. This is a negative return on the project (£2,100), so the project would be rejected.

Net present value (3)Advantages Considers the time value of money. Takes into account all years and therefore profitability.

 

Disadvantages Can be complex to calculate, though discount factors are given in

the exam. Can be quite negative, as most projects end up being rejected. It’s only a forecast (can be very unpredictable). The interest rates used are often unrealistic, e.g. 10% rates do not

reflect reality.