When considering a major purchase a firm will take into account: • The initial cost• Future benefits e.g. revenues, residual value• Future costs e.g. interest payments, depreciation• Alternatives e.g. other projects and uses of funds• The degree of risk - which will vary with the

economic climate

• Investment appraisal looks at how to answer the question 'is it worth investing in that project?'

• The methods used require two main pieces of information– The capital cost of the project – The value of the project (what cash will it

bring in for the cost?)

• Investment appraisal is a forward-looking process. It considers what might happen, and makes forecasts. These are then used to make calculations and analyses. However, these forecasts will always contain elements of inaccuracy, uncertainty and risk and we learn in these sections also how to take account of this.

• Investment appraisal is built around estimates of future cash flows - cash flow into and out of the company as a result of a particular investment project.

• These are almost certainly not entirely accurate. The capital cost will not really be known until it is actually done. Plus or minus 5% would be a good level of accuracy from a good, experienced project team. Cash inflows are also notoriously hard to predict with any accuracy.

Cash Outflow

• This is all the costs of the project. It will be built up by the 'Projects Department', probably by engineers. It may be built up of a series of sub-estimates that are all put together to get the overall cost.

Cash Inflow

• This is the estimate of the value of the project. It is expressed in terms of net cash inflow.

Net Cash Flow• The cash the project will bring in, (sales

revenue) less annual costs incurred in the manufacture and sale of the product.

• The heart of the forecast of net cash inflow is the sales forecast produced by the marketing department. This may possibly be inaccurate as it is a forecast. This inaccuracy may be magnified if there are also problems with the cost side of net cash inflow.

Net Cash Flow• Notice that a cash flow forecast is not a

profit forecast. We are concerned with real money here.

• Cash inflows often tend to be overestimated. Who has ever come across a pessimistic brand manager? Marketing people tend to be optimists - the product will sell well - so the sales forecast will probably be an overestimate of the real situation.

Reasons for inaccuracy are:• Firms do not work in a vacuum. They cannot predict

accurately the actions of the competition, the development of the market, changes in consumer taste, and changes in the economy and government regulation.

• Firms cannot predict the prices of materials, or the cost of labor in advance.

• Some items cannot be predicted in advance. • The weather may be very unseasonable and cause sales to

be different to the forecast.

Thus there is a considerable element of risk when these figures are used.

• It is important when considering the results of investment appraisal operations to be aware of the source and the quality of the data involved. An allowance should be made for the risk element.

Investment appraisal techniques• Firms have to decide if they should invest

in projects or not. They have to make choices between projects, or decide if they should stay as they are. This is the area if investment appraisal, the process which gives help and assistance in decision making situations.

The basic requirements of investment appraisal are:

• An estimate of what the project will cost. This is the capital investment.

• An estimate of what the project will earn the firm. This is called the forecast of net cash inflow.

Investment appraisal methods divide into two groups:

• Simple, easy to calculate methods. They are not very accurate or sensitive, but are good for screening out poor projects from a long list. All projects should be subjected to these tests. These screening tests are– Payback period – Average rate of return (ARR)

Investment appraisal methods divide into two groups:

• If a project passes through the first screening, then it is subjected to the next set of detailed, accurate tests. These complex tests are based on discounted cash flow methods. The main tests are– Discounted cash flow (DCF)*– Net present value (NPV) *

*HL only

Payback Period (PBP)

• Refers to the amount of time needed for an investment project to earn enough profits to repay the initial cost of the investment.

Formula:Initial investment cost Contribution per month

Page 310 – 311 Examples

A newspaper considering the purchase of a new printing machine is faced with the choice between ‘The Printswell’ and ‘The Hotpress’ both initially costing £120,000 The Printswell The Hotpress

Year Net Return (profit)

Cumulative Return

Net Return (profit)

Cumulative Return

1 30 60

2 30 50

3 40 40

4 60 36

5 50 20

6 30 10

Payback is the time it takes to recover the original investment costSteps: Calculate the cumulative net annual return The payback year is when the cumulative return equals

the capital outlay To calculate the number of days in the payback year,

divide the amount required to complete the payback by the return in that year and multiply by 365

The Printswell = 3 years 122 days (since 20/60 x 365 = 122)

The Hotpress = 2 years 91 days (since 10/40 x 365 = 91)

Advantages• easy to calculate• provides a useful

measure of risk (Hotpress is a safer bet)

• the shortest payback is useful where:

­ technology or consumer tastes change rapidly (helps to avoid assets becoming obsolete)

­ funds are limited - helps reduce indebtedness & cashflow problems

Disadvantages• ignores timing of

returns• ignores all net returns

after the payback date• takes no account of

the long-term profitability of a project

ARR• This is a measure of profit, and it is in the

familiar percentage form. It has its attractions to some people, as it is quite a straightforward measure of return. The average rate of return looks at the average net gain made per year, expressed as a percentage of the initial investment.

The average profit generated per year by a project is expressed as a % of the initial amount invested and the highest ARR is chosen

Steps:add up the annual returns (or cash inflow)deduct the initial cost (to get the overall profit)divide by the number of useful years (to get the

average return per year)divide this figure by the initial cost and x 100 (to get

the ARR)

ARR = average return per year/ initial amt invested x 100

The Printswell = 16.7% The Hotpress = 13.3%

Page 312Examples

Practice•

Project X Project YProject Z

• Cost £50,000 £40,000£90,000

• Return Yr 1 £10,000 £10,000£20,000

• Yr 2 £10,000 £10,000£20,000

• Yr 3 £15,000 £10,000£30,000

• Yr 4 £15,000 £15,000£30,000

• Yr 5 £20,000 £15,000£30,000

• Total £70,000 £60,000£130,000

• Steps to calculate the ARR:1. Calculate the profit from each project (total return – cost).2. Calculate the average profit per year (total profit ÷ No of years).3. Calculate ARR.

SOLUTION Project X Project Y

Project Z

Cost £50,000 £40,000 £90,000

1. Total Profit £20,000 £20,000 £40,000

2. Profit £4,000 £4,000 £8,000per year

ARR 8% 10% 8.9%

Advantages• takes account of

returns over the whole life of a project

• provides a comparison with the returns available on alternative uses of funds

Disadvantages• ignores the timing

of returns e.g. a project with high returns in the early years may be more preferable to one that is more profitable overall

• Ignores the effect of inflation on the value of money over time

• So, with all of the problems associated with these methods of analysis, what are they used for?

• They are simple and quick to prepare, and are used as screens to weed out poor, or useless, projects.

• Firms have to set themselves 'action standards' for payback and ARR, say 3 years maximum and 15% minimum, and only if these are met and/or exceeded will a project 'pass' to be examined by the more complex discounted cash flow method.

• Action standards are selected by the firm concerned to reflect their view of the future and individual requirements.

To what extent are quantitative investment appraisal methods useful when choosing between

investment projects?

Limitations of Investment Appraisal:• relies on forecasts which may prove to be

highly inaccurate• only considers quantitative factors - takes

no account of qualitative factors such as staff attitudes to a project

• takes account of internal or ‘private’ costs and ignores any external costs i.e.‘social costs such as pollution