Investment Appraisal - 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.
Average Rate of Return
- 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.
Net Present Value
- 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.
A practical exercise
£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
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.