Investment Appraisal

What is an investment appraisal?

• Evaluating the profitability of an investment project • There are 3 methods of quantitative investment appraisal

which are:• Payback period

• Average Rate of Return• Net Present Value using discounted cash flows

Payback period

• Length of time it takes for the net cash inflows to pay back the original capital cost of the investment

Example 1

Method: Payback Period

• The annual cash flow in year # depends on how much time the debt can be repaid. For example in Team B, the cost of take over is $70m. We have to calculate in which year the business is able to repay its debt so that we can find the additional cash inflow needed. Team B has a cash inflow of $15m in year 1, $18m in year 2, $21m in year 3, $24m in year 4 and $30 in year 5. From these figures, we have to calculate in which year whether the total amount of cash inflow is either equal or greater than the initial cost of the investment. This will fit into the denominator of the equation.

• To calculate ‘additional cash inflow needed’, we take the # from the denominator and minus it by 1 to find the total cash inflow from year 1 to that number. E.g. ‘Annual cash flow in year #’ is 4 so subtracting 1 from it will result to year 3. Add the values together of year 1, 2 and 3 to give you the total cash inflow in those years. Take the initial cost of investment and subtract it to get the ‘additional cash inflow needed’.

Method: Team B • Initial cost of investment: $70m• Cash inflow for year:• 1: $15m• 2: $18m• 3: $21m• 4: $24m• 5: $30m• Year 1 + 2 + 3 + 4 = 15+18+21+24 = $78m

• Which means that year 4 is when the debt will be repaid.• 4th year – 1 year = 3rd year

• Total cash inflow in year 3 = 15+18+21 = $54m• Initial cost of investment – Total cash inflow in year 3 = Additional cash inflow needed.

• 78-70 = $8m

Total payback period = 3 years and 4 months

Advantages & Disadvantages of using Payback Period

Advantages DisadvantagesQuick & easy Not profitableShort term Long term will be unprofitable Important for liquidity

Average Rate of Return (ARR)• It measures the annual profitability of an investment as a

percentage of the initial investment

• We have to assume that the net cash flow = profit• Annual profit =

Example - ARR• Team A • Initial capital cost: $200m• Expected returns in year• 1: -30• 2: -2• 3: 76• 4: 96• 5: 150• 29%

Advantages & Disadvantages of ARR

Advantages Disadvantages

Uses all cash flow years – unlike payback period

Average = constant. In reality, cash flow maybe periodic/erratic

Life-cycle of capital Unreliable forecast especially distant future

Easily understood if compared Forecasted cash flows have not been discounted

Profitability objectives

Net Present Value • Todays value of the estimated cash flows resulting from an

investment • Uses discounted cash flows

Method:1. Multiply discount factors by the cash flows. Cash flows in year 0 are never discounted as they are today’s values already

2. Add the discounted cash flows

3. Subtract the capital cost to give the NPV

Example – Net Present Value • Team B • To get the future value, multiply the present value($m) by the

discounted rate(inflation)

• Then add all the future values = 79.308 = 79.31 (2dp)• Subtract the initial cost of capital by the total of future values to

give you the Net Present Value (NPV) • NPV = $9.31m

Year $m 10% Interest Rate

Future Value

1 15 0.9091 13.64

2 18 0.8264 14.88

3 21 0.7513 15.78

4 24 0.6830 16.39

5 30 0.6209 18.63

Advantages & Disadvantages of Net Present Value

Advantages Disadvantages

Considers both timing and size complex

Varied discounts depending on economic conditions

Interest rates are unpredictable

Opportunity costs