3.
7 Investment appraisal
Investment appraisal- process of analysing whether investment projects are worthwhile- helps business decide what
projects to invest in, to get the best, fastest least risky return for their money.
§ Faster money comes in – less risk
Must balance risk and return:
§ Businesses often need to invest to achieve their objectives. Investment is always risky – businesses want risk to be
low and reward high
Payback period- the time it takes for a project to repay its initial investment (Time: days/ years)
Average rate of return- total accounting return for a project to see if it meets the target return (% return)
Discounted cash flow (NPV)- calculates the monetary value now of the projects future cash flows (£)
Average rate of return compares net return with investment
Net return= income of project – costs (including investment)
§ Higher the ARR- more favourable project will appear Disadvantages:
1. Calculate the average annual profit from the investment project
§ Ignores timing of the cash flows
2. Divide average annual profit by initial investment (outlay)
e.g. a company might put more
3. Compare with target % return
value on money that they get
Advantages: sooner rather than later
§ Focuses on profits rather than cash
§ Easy to calculate and simple to understand flows
§ Focuses on the overall profitability of an investment project § Ignores time value of money
§ Easy to compare ARR with other key target rates of return to help decide
§ Uses all the return generated by a project
§ Takes account of all projects cash flow after a certain point
Payback period measures the length of time it takes to get your money back:
§ time it takes for a project to repay its initial investment (Time: days/ years)
Identify net cash flows for each period Disadvantages:
Keep a running total of the cash flows § Ignores cash flow after
payback has been reached
§ Initial investment= an outflow
§ Takes no account of the
§ When does the running total move from negative (outflow) to positive (inflow)
‘time value of money’ (risk)
§ When the total net cash flow becomes positive= end of payback period
§ May encourage s/t thinking
Advantages: § Ignores qualitative aspects
§ Doesn’t actually create a
§ Easy to calculate and understand decision for the investment
§ Focuses on cash flows
§ Emphasises speed of return; good for markets which change rapidly. Straight forward to compare competing proj
§ Very good for high tech projects. Tech tends to become obsolete so businesses need to be sure they’ll get initial
investment back or any project that might not provide long term returns
Discounting adjusts the value of future cash inflows to their present value
Discounting- method used to reduce the future value of cash flows to reflect the risk that they may not happen
§ Done so investors can compare like with like when they look at cash inflows they’ll receive
§ Can be seen as the opposite of calculating interest. Done by multiplying the amount of money by a discount
factor. Discount rate= always less than 1 - value of money in future is always less than its value now
§ Depend on what the interest rate is predicted to be. High interest rates – future payments have to be
discounted a lot to give correct present value= present value represents the opportunity cost of not investing in
bank – earn a high interest rate
§ Interest rates are low- future cash inflow doesn’t need to be discounted – less OC
The future value of cash inflow depends on risk and opportunity cost
§ Risk and opportunity cost – increase the longer you have to wait for money- it’s worth less
§ This is called the time value of money. Better off getting money now: years time money is worth less – inflation.
There’s an OC
The time value of money:
§ Better to receive cash now than in future
§ Future cash flows worth less
§ Use discount factor
§ Cash flow X discount factor= present value
Net present value is used to calculate return
§ Discounted cash flow is an investment appraisal tool that uses NPV to calculate return of project
§ Net present value – value of project assuming all future returns are discounted to what they would be worth if
you had them now, always less than their face value (inflation). Add together all present values of future cash
flows
Negative NPV- business could get a better return by putting money in savings account. Businesses go ahead with
positive NPV.
Downsides of discounted cash flow- hard to calculate- difficult for businesses to work out what the discount factor
ought to be- because they don’t know what the bank I/R are going to be in future. The longer the project is set to
last, the harder it’s to predict discount factor
Benefits of using NPV:
§ Considers all future cash flows
§ Reflects risk that future cash flows will not be as expected
§ Different levels of risk can be accounted for by adjusting discount rate
§ Creates a straight forward decision positive NPV suggests project should go ahead
Disadvantages:
§ Most complicated method
§ Choosing discount rate is hard, esp for long projects
§ Result can be influenced/ manipulated using the discount rate
Non – numerical, qualitative factors affect investment decisions:
Managers must put decisions into a qualitative context, based on internal factors and market uncertainty
There’s always risk and uncertainty:
§ All investment appraisal methods are based on predictions about how much income they can generate from
investments. Difficult to accurately predict whats going to happen in future, cant always rely on predictions.
§ Market environments are always uncertain- circumstances might change unexpectedly – negative impact.
Exchange rates may alter, sales may decrease, tastes may change
§ Any change in circumstances that business base their investment predictions on mean their predictions no
longer valid
§ Every firm has a different attitude to risk- some happy to take big risks- financial reward
§ Good idea to have a set of investment criteria- conditions that need to be met for investment to be approves.
Sensitivity Analysis - a technique which allows the analysis of changes in assumptions used in forecasts
Most decisions rely on certain assumptions about future events e.g. an investment decision might be based on the
assumption that the price of raw materials will increase by 8% over next 3 years, sales rev increase by 3% each
year- make a scenario for future called base case
Assumptions:
§ Investment appraisal- timing and amount of project cash flows, period over which project will run, amount of
initial investment
Sensitivity analysis:
§ How reliable assumptions made
§ What happens if assumption turn out to be sig different in reality
§ Which assumptions most significant to forecast
Looks at the base case and considers what would happen if you alter the assumption, e.g. raw mat increase by 10
to 15%. Analysing several factors – specialist software
Disadvantages:
Sensitivity analysis benefits
§ Only tests one assumption at a
§ Allows key assumptions to be changed to analyse effect time
§ Helps judge degree of risk in an investment project § Only as goods as data on which
§ Recognises that there is no such things as an accurate forecast forecasts are based
§ Considers one variable or assumption at a time § A somewhat complicated
§ Identifies the most significant assumption (requires closer attention) concept- not understood by all
§ Helps assess risk and prepare for less than favourable scenario managers
§ Helps make the process of business forecasting more robust
Factors influencing investment decisions
Financial:
§ Investment criteria
§ Total returns and sensitivity
§ Alternative investments
§ Financial position
Non-financial factors:
§ Corporate objectives
§ Organisational culture and attitude to risk
§ Management confidence in the investment appraisal data
§ Business image and reputation
