+ Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the...
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Transcript of + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the...
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Investment Appraisal
+What is investment appraisal?
Techniques to help managers decide on the best investment from a range of options
Investment includes purchase of plant, vehicles, buildings or investing money
Financial investment appraisal techniques are used alongside non financial factors
Different methods can be used and all have their own advantages and disadvantages
+Information needed …
Before you can undertake any investment appraisal you need to know: The amount of the investment (eg how much will it cost) How long the investment will last The income associated with the investment – this may be
expressed as profit or cashflow
+For example
Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4.
+Methods
Traditional Payback Accounting rate of return (ARR)
Non-traditional (Discounted cash flow) Net Present Value Internal Rate of Return
+Payback How long will it take to ‘payback’ the initial investment?
The easiest and quickest method of appraisal
Can decide quickly whether the payback period is acceptable – company may have a cut-off period
Short payback projects may improve a company’s liquidity
Short payback projects may be less risky
BUT payback doesn’t take into account the ‘time value’ of money
AND payback doesn’t take into account cash flows after the payback period
THEREFORE it is only used as a first level of investment appraisal
+Calculating Payback: Construct a Payback Table
Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4.
Year Annual Cash Flows
Cumulative
+Calculating Payback: Fill in the Payback Table
Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4.
Year Annual Cash Flows
Cumulative
0 (15,000) (15,000)
1 10,000 (5,000)
2 6,000 1,000
3 3,000 4,000
4 1,000 5,000
+Calculating Payback
Year Annual Cash Flows
Cumulative
0 (15,000) (15,000)
1 10,000 (5,000)
2 6,000 1,000
3 3,000 4,000
4 1,000 5,000
• Payback sometime during Year 2
• Assuming all cash flows are equally spread throughout the year:• 5,000/6000 x
365 = 304.16• Round UP• Payback
period = 1 year and 305 days
+Accounting Rate of Return
Average profit against average investment, expressed as a %
Enables managers to compare returns from one investment against expected returns from other investments
Managers may have a specific ARR that they are aiming to achieve
Simple to calculate
Takes account of profits over the whole life of the project
HOWEVER, does not take into account time value of money
AND is based on accounting profit, not cash flow
+Calculating Accounting Rate of Return
Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4.
Average Profit / Average investment x 100
Revenue – Expenses = Profit
+Calculating Accounting Rate of Return
Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4.
Average Profit / Average investment x 100
Revenue – Expenses = ProfitAlways check the question – are the figures cash flow or profits? In this
case they’re cash flows so you need to calculate the profits
+Calculating Accounting Rate of Return
Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4.
Average Profit / Average investment x 100
Revenue – Expenses = Profit(10,000+6,000+3,000+1,000) – 15,000 = 5,000Average Profit = 5,000/4 years = £1,250
Average Investment = (Investment at start + book value of investment at end) / 215,000 / 2 = 7500
+Calculating Accounting Rate of Return
Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4.
Average Profit / Average investment x 100
Revenue – Expenses = Profit(10,000+6,000+3,000+1,000) – 15,000 = 5,000Average Profit = 5,000/4 years = £1,250
Average Investment = (Investment at start + book value of investment at end) / 215,000 / 2 = 7500
Investment at start £15,000This was depreciated over the 4 years
so investment at end is £0
+Calculating Accounting Rate of Return
Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4.
Average Profit / Average investment x 100
Revenue – Expenses = Profit(10,000+6,000+3,000+1,000) – 15,000 = 5,000Average Profit = 5,000/4 years = £1,250
Average Investment = (Investment at start + book value of investment at end) / 215,000 / 2 = 7500
ARR = 1,250 / 7500 x 100 ARR = 17%