Investment Appraisal - The process of analysing the financial merits of a possible future investment.
The techniques help a business decide whether the investment is worthwhile or not. It also helps to compare options and choose the best one when comparing the different techniques.
The 3 different techniques of Investment Appraisal are;
- Average Rate of Return
- Net Present Value
With all of the above, it is crucial to work out the yearly cash flow for each option.
Investment Appraisal - Payback
Payback - A calculation of how long it will take to recoup the cost of an initial investment.
To work out payback;
1) The first step of working out payback is to add up the net cash flows until the figure ends up being enough to cover the initial cost of the investment.
REMEMBER to include the year 0 cash flow that will always be negative due to the intial cost.
Once this has been done, we know that by year 'x', there is enough money to cover the initial investment. Therefore, the payback is 'x' years and 'y' months.
2) The final step is to work out how many months it will take to payback. To do this...
Calculate the amount still needed for the option, divide by the net cash inflow for the year found as 'x' and thern multiply by 12.
Payback - Advantages & Disadvantages
The shorter the payback period, the less risk is involved in the option as the firm will see a return on the money invested.
Advantages; - Simple to calculate
- Easy to interpret
Disadvantages; - Fails to take into account any inflows after payback
- Ignores overall profitability of project
- Assumes that in the year of payback, the inflow of cash is steady.
Investment Appraisal - Average Rate of Return
Average Rate of Return - Asses the worth of an investment by calculating the average annual profit expressed as a percentage of the initilal investment.
Step 1) Calculate the average annual profit by adding up all the net cash flows. Once this has been found, divide this figure by the number of years.
REMEMBER TO INCLUDE THE NEGATIVE INITIAL COST!
e.g (Year 0 + Year 1 + Year 2 + Year 3 + Year 4) / 4 = Average Annual Profit
Step 2) Divide the figure previously attained, by the cost of the initial investment. After, times this answer by 100 to work the ARR out as a percentage.
e.g. (Average annual profit / Initial Investment) x 100
This works out the ARR.
Average Rate of Return - Advantages & Disadvantage
The higher the ARR, the more potentially profitable the investment could be.
Advantages; - Allows easy comparison with other forms of investment
- Can be compared to a current or target ROCE
Disadvantages; - Doesn't take into account the timings of the cash flows
Investment Appraisal - Net Present Value
Net Present Value - The total return of an investment staated in today's monetary value.
The Net Present Value recognises that £100 received today is worth more than £100 received in the future. To calculate the decrease in value, a discount factor is used.
Step 1) Multiply each year's net inflow by the relevant discount factor.
THE INITIAL INVESTMENT IS ALWAYS MULTIPLIED BY 1. Therefore the NPV of year 0 is always the same as the initial cost.
Step 2) Add up all the NPV's to calculate the net cash gain from the project expressed in today's terms.
NPV - Advantages & Disadvantages
How to choose with project to use by NPV;
- If it is predicted to have a positive NPV, it should be accepted.
- If choosing between two, the higher NPV should be chosen.
- If the present values of the inflows is less than present value of outflows, then is should be rejected.
Advantages; - Takes into account time value of money
Disadvantages; - Doesn't take into account the speed of repayment
- Can be difficult to choose the correct discount factors
- Concept may be hard to understand for non-financial managers.