1 Investment Appraisal Techniques. TOPIC:Topic 3: Accounts & Finance LESSON TITLE: Investment Appraisal LEARNING INTENTION: To understand what investment

1

Investment Appraisal Techniques

TOPIC: Topic 3: Accounts & Finance LESSON TITLE: Investment AppraisalLEARNING INTENTION: To understand what investment appraisal is and to be able to use IA techniques to calculate payback on investment.

COMPETENCY FOCUS:

Key Skills (Numeracy): to develop your numeracy skills through the calculation of investment appraisal techniques.

[IB Learner Profile Development: Logical]

Success CriteriaBy the end of the lesson, I can…

1) Define the term investment appraisal2) Explain why investment appraisal is calculated by businesses3) Calculate the payback period of an investment.

SMSC: You will assess the state of the organisation’s financial investments using calculations.

CRITICAL THINKING KEY:

Knowledge Application Analysis Evaluation

Investment Appraisal

3

What do you understand by the term Investment Appraisal?

Investment appraisal involves a series of techniques, which enable a business to evaluate the profitability of an investment.

Investment Appraisal

4

It is a techniques use to determine if a particular investment is worthwhile.

It can be used to compare different projects to determine which is more favourable.

5

Types of Investment Appraisal Techniques?

Payback Period (PBP)

Net Present Value (NPV)

Accounting Rate of Return (ARR)

Advantages of the payback method

Payback is an easily understood concept.

The calculation is quick and simple

Shorter-term forecasts are likely to be more reliable.

It is a measurement of Investment risk as risk is increased if payback is longer.

A business may have borrowed money from bank to fund the investment therefore a longer payback will increase interest payments.

6

Disadvantages of the payback method

It ignores the timing of cash flows within the payback period.

It also ignores the cash flows after the end of the payback period and therefore the total project return.

It ignores the time value of money. This means that it does not take account of the fact that £1 today is worth more than £1 in one year's time.

The method is unable to distinguish between projects with the same payback period.

It may lead to excessive investment in short-term projects.

7

Example

Yr0 Yr1 Yr2 Yr3 Yr4 Yr5

Net Cash Flow

(500) 100 125 125 150 150

Cumulative Net Cash Flow

(500) (400) (275) (150) 0 150

8

1) What is happening in yr0?2) How long will it take for the initial investment to be

covered and a profit is starting to be made?

Practice Question

9

Calculate the PBP for the two projects.

What if the payback period falls between 2 years?

Amount required

Net Cash Flow in Year x12 =

10

Now have a go…

Case study

P189 Question 1

P193 Question 1

11

TOPIC: Topic 3: Accounts & Finance LESSON TITLE: Investment Appraisal - ARRLEARNING INTENTION: To understand what investment appraisal is and to be able to use IA techniques to calculate payback on investment.

COMPETENCY FOCUS:




1) To define ARR2) To calculate ARR (average rate of return).




Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR) expresses the average profit per annum as a percentage of the

capital outlay.

The decision rule (criterion rate) is that projects with an ARR above a defined minimum as set by

the organisation are acceptable; however the general rule is that the greater the ARR, the

more desirable the project.

13

ARR = (total returns – capital outlay)

Years of usage

x100

Capital Cost

14

Calculating the accounting rate of return

Practice Questions

15

Advantages

It is quick and simple to calculate.

It involves a familiar concept of a percentage return.

Accounting profits can be easily calculated from financial statements.

It looks at the entire project life

16

Disadvantages

It is based on accounting profits rather than cash flows, which are subject to a number of different accounting policies.

It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment.

It takes no account of the length of the project.

Like the payback method, it ignores the time value of money

17

Practice Questions

Pg189 Activity 19.2 [Old book]

Pg239 Question C [New book]

18

TOPIC: Topic 3: Accounts & Finance LESSON TITLE: Investment Appraisal – NPV (HL ONLY)LEARNING INTENTION: To understand what investment appraisal is and to be able to use IA techniques to calculate payback on investment.

COMPETENCY FOCUS:




1) To define NPV2) To calculate NPV (net present value).





This takes into account the time value of money. It is based on the principle that money is worth more now than it is in the future. The principle exists for two reasons:

20

Risk – money in the future is uncertain.

Opportunity cost –could be in an interest account earning interest.

Therefore… today’s value of the investment!


NPV = present value of cash inflows minus present value of cash outflows.

21

If the NPV is positive, it means that the cash inflows from a project will yield a return in excess of the cost of capital, and so the project should be undertaken.

If the NPV is negative, it means that the cash inflows from a project will yield a return below the cost of capital, and so the project should not be undertaken.

NPV=PVCI-PVCO

If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly the same as the cost of capital.

Advantages Considers the time value of money.

It considers all relevant cash flows, so that it is unaffected by the accounting policies which affects profit-based investment appraisal techniques such as ARR

Reducing discounting rate reduces future monies more heavily.

Only one method that gives a definitive answer.

Positive return – it is worth doing 22

Disadvantages

Time consuming.

More difficult to understand.

Based on an arbitrary choice of interest rate.

23

Practice Questions

24

Case Study

Read case study on pg.193.

Respond to comprehension questions.

1hr

25

Documents

1 Investment Appraisal Techniques. TOPIC:Topic 3: Accounts & Finance LESSON TITLE: Investment Appraisal LEARNING INTENTION: To understand what investment