Business Studies A2

Payback

–        ignores profit and time value of money.

–        If the business wants the initial outlay back quickly, use this method

–        Its easy to understand and calculate.

ARR

-          takes into account the profit of the investment

-          you can compare the profit % returns between different investment projects.

-          Ignores the time value of money.

-          The higher the ARR the better.

-          the most complex appraisal method

-          takes into account the time value of money by using discount factors.

-          A lot depends on the discount factor % used.  The lower rate the less the net cashflows are discounted by making the investment look good.  Higher rates = lower returns over time.

-          How do you choose the discount factor, link to current inflation rates and the level of risk attached to the project.  Higher risk of net cashflow not occurring = use higher discount rate.  Less risky project then use a lower discount factor.

-          Biggest positive NPV is good.

With any investment project there are many other issues other than financial.  E.g. if the investment project is a purchasing a new machine then workers might have to be made redundant (associated costs and effect on moral of current workers?).  Also workers may need additional training, therefore additional costs for this.

 If a business wanted to move production to Spain from the UK.  Financially this might be really good i.e. lower breakeven, higher profits, high ARR, quick Payback and high positive NPV.  However, 500 workers made redundant in UK, (poor publicity, costs etc.), might not be able to find a buyer for the UK factory/land, customers unhappy about product ‘made in Spain’ instead of UK.  UK suppliers let down by the UK company (will now be sourcing supplies from Spain!).  The language barriers, different work ethos in Spain (e.g. siestas).  Different working hours, labour and work laws etc.

     £500,000 to purchase machines for factory

 Yr    Cash inflows              Cash Outflows     Net cashflow

1        150,000                              40,000                  ?

2        175,000                              50,000                  ?

3        250,000                             60,000                  ?

4        200,000                             65,000                  ?

5        175,000                              65,000                  ?

 Calculate the Payback, ARR and NPV.

Discount Factor 8% =

Yr1 0.93; Yr2 0.86; Yr3 0.79; Yr4 0.74; yr5 0.68

Net Cashflows

Yr 1 = £110,000             Payback = Yr 3 = £425,000  need to find a further £75,000 from

Yr 2 = £125,000             Yr 4.  Divide £135,000/12 months = £11,250. Then

Yr 3 = £190,000             £75,000/£11,250 = 6.66 months. Answer = 3 yrs 7 months.

Yr 4 = £135,000             ARR = £670,000 minus £500,000 = £170,000 profit,

Yr 5 = £110,000             To find the average annual rate of return divide £170,000/5yrs

Total = £670,000            = £34,000/500,000 * 100 = 6.8% ARR (is this good enough?).

NPV = £534,600 minus £500,000 = + £34,600 which is good, its positive, but are there any other projects that could provide a higher return, and is the discount factor we have used appropriate.