Investment Appraisal
·
A means of assessing whether an investment project is
worthwhile or not
·
Investment project could be the purchase of a new PC
for a small firm, a new piece of equipment in a manufacturing plant, a whole
new factory, etc
·
Used in both public and private sector
Investment
Appraisal
§ Why do companies invest?
Importance of remembering
investment as the purchase of productive capacity NOT buying stocks and shares
or investing in a bank!
§ Buy equipment/machinery or
build new plant to:
-
Increase capacity (amount that can be produced) which
means:
* Demand can
be met and this generates sales revenue
* Increased
efficiency and productivity
·
The length of time taken to repay the initial capital
cost
·
Requires information on the revenue the investment
generates
·
e.g. A machine costs £600,000
·
It produces items that sell at £5 each and produces
60,000 units per year .
·
Payback period will be 2 years
Payback
method
§ Payback could occur during a
year
§ Can take account of this by
reducing the cash inflows from the investment to days, weeks or years
Days/Weeks/Months x Initial Investment
Payback =
------------------------------------------------------------
Total Cash Received
Payback Method
o e.g.
-
Cost of machine = £600,000
-
Annual income streams from investment = £255,000 per
year
o
Payback = 36 x 600,000/765,000
= 28.23 months
(2
yrs, 6¾ months)
|
Income |
|
|
Year
1 |
255,000 |
|
Year
2 |
255,000 |
|
Year
3 |
255,000 |
Accounting
Rate of Return
·
A comparison of the profit generated by the investment
with the cost of the investment.
Average annual return or
annual profit
·
ARR = ------------------------------------------------------------
Initial cost of investment
Accounting
Rate of Return
§ e.g.
§ An investment is expected to
yield cash flows of £10,000 annually for the next 5 years
§ The initial cost of the
investment is £20,000
§ Total profit therefore is:
£30,000
§ Annual profit = £30,000 / 5
= £6,000
ARR = 6,000/20,000 x 100
= 30%
A worthwhile return?
Net
Present Value
Ø Takes into account the fact
that money values change with time
Ø How much would you need to
invest today to earn x amount in x years time?
Ø Value of money is affected by
interest rates
Ø NPV helps to take these
factors into consideration
Ø Shows you what your investment
would have earned in an alternative investment regime
Net
Present Value
-
e.g.
-
Project A costs £1,000,000
-
After 5 years the cash returns = £100,000 (10%)
-
If you had invested the £1 million into a bank
offering interest at 12% the returns would be greater
-
You might be better off re-considering your
investment!
§ The principle:
§ How much would you have to
invest now to earn £100 in one year’s time if the interest rate was 5%?
§ The amount invested would need
to be: £95.24
§ Allows comparison of an
investment by valuing cash payments on the project and cash receipts expected
to be earned over the lifetime of the investment at the same point in time, i.e
the present.
Future
Value
PV
= ---------------------------------------
(1 +
i)n
Where i = interest rate
n = number of years
·
The PV of £1 @ 10% in 1 years time is 0.9090
·
If you invested 0.9090p today and the interest rate
was 10% you would have £1 in a year’s time
·
Process referred to as:
·
‘Discounting Cash Flow’
·
Cash flow x discount factor = present value
·
e.g. PV of £500 in 10 years time at a rate of interest
of 4.25% = 500 x .6595373 = £329.77
·
£329.77 is what
you would have to invest today at a rate of interest of 4.25% to earn £500 in
10 years time
·
PVs can be found through valuation tables (e.g.
Parry’s Valuation Tables)
Discounted
Cash Flow
v An example:
v A firm is deciding on
investing in an energy efficiency system. Two possible systems are under
investigation
v One yields quicker results in
terms of energy savings than the other but the second may be more efficient
later
v Which should the firm invest
in?
Discounted
Cash Flow
§ System A represents the better
investment
§ System B yields the same
return after six years but the returns of System A occur faster and are worth
more to the firm than returns occurring in future years even though those
returns are greater
Internal
Rate of Return
v Allows the risk associated
with an investment project to be assessed
v The IRR is the rate of
interest (or discount rate) that makes the net present value = to zero
-
Helps measure the worth of an investment
-
Allows the firm to assess whether an investment in the
machine, etc. would yield a better return based on internal standards of return
-
Allows comparison of projects with different initial
outlays
-
Set
the cash flows to different discount rates
-
Software
or simple graphing allows the IRR to be found
Profitability
Index
·
Allows a comparison of the costs and benefits of
different projects to be assessed and thus allow decision making to be carried
out.
Net Present Value
Profitability
Index = -----------------------------------
Initial Capital Cost
Investment
Appraisal
Key
considerations for firms in considering use:
Ease of use/degree of
simplicity required
Degree of accuracy required
Extent to which future cash
flows can be measured accurately
Extent to which future
interest rate movements can be factored in and predicted
Necessity of factoring in
effects of inflation.
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