+ Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the...

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+ Investment Appraisal

Transcript of + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the...

Page 1: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

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Investment Appraisal

Page 2: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 3: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 4: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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.

Page 5: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+Methods

Traditional Payback Accounting rate of return (ARR)

Non-traditional (Discounted cash flow) Net Present Value Internal Rate of Return

Page 6: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 7: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 8: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 9: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 10: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 11: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 12: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 13: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 14: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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

Page 15: + Investment Appraisal. + What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes.

+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%