BUSINESS AND MANAGEMENT

MODULE 6

ACCOUNTING AND FINANCE

Unit 6.2: Investment Appraisal Methods

Reading Focus1. Barratt and Mottershead. AS and A Level Business Studies,

Unit 39.

2. Hall, Jones, Raffo. Business Studies 3rd Edition, Unit 50

3. Jewell. An Integrated Approach to Business Studies, Unit 30

4. Stimpson. AS and A Level Business Studies, Chapter 29

CONTENT

Investment Appraisal Methods

Payback MethodARR (Accounting Rate of Return)DCF (Discounted Cash Flow)NPV (Net Present Value)IRR (Internal Rate of Return)

Learning OutcomesMake calculations from given data and analyse the results

CONTEXT

When a business makes an investment, this usually refers to the purchase of capital goods such as plant and equipment. It is important for any business to be able to decide whether particular investment is going to be ‘worthwhile’. It is also important to be able to compare potential investments plans assuming it is not possible to undertake all such projects at the same time.

When assessing whether to carry out an investment businesses would have to balance the initial cost against the benefits of such investment.

Several criteria can be used to judge whether long – term investment is worth carrying out. The business may consider how quickly the investment is recouped ( Payback), assess the profitability of the investment (Accounting Rate of Return). The business would also have to consider the effect of redundancies on the work – force and perhaps the need for training to use new machinery.

The Nature of InvestmentInvestments refers to the purchase of capital goods. Capital goods are

used in the production of other goods, directly or indirectly.

Investment can also be referred to expenditure by a business which is likely to yield a return in the future.

Investment can be autonomous or induced.

Autonomous Investment – when the firm buys capital goods to replace ones which have worn out.

Induced Investment – Any new investment by the firm resulting from rising sales or expansion.

Types of Investments

1. Capital Goods2. Construction3. Stocks4. Public Sector Investments

What are the risks associated with investments?

Read: Jones, Hall, Raffo, Business Studies 3rd Edition, Unit 50, page 350

Case: Question 1Source: Jones, Hall, Raffo, Business Studies 3rd Edition, Unit 50, page

350

The Determinants of Private Sector Investment

MOTIVES

Autonomous investmentCompetitive PressureChange in Technology

Growth

BUSINESS CONFIDENCE

Past Success with investment

State of the EconomyExisting Capacity

Order Levels

REVENUE

Expected SalesPrice

Rivals’ Behaviour

COST

Capital CostOpportunity Cost

Variable Cost

EXTERNAL FACTORS

Exchange RatesInterest Rates

InflationGovernment Policies

World Affairs

INVESTMENT DECISION

?

RETURNS

Question: What factors determine the extent of Public Sector investments?

How are investments assessed?The Payback Method

One method of measuring the success of any proposed investment is to calculate how quickly the cost of the investment can be recouped. The quicker the payback period the better.

Project A Project B

Cash Flow

End of Year 0 - 40,000 -40,000

EOY 1 20,000 40,000

EOY 2 30,000 30,000

EOY 3 40,000 20,000

How are investments assessed?

Cash flow means revenue minus operating cost, assuming all transactions are in cash. This does not include the investment costs.

End of year means that the cash flow comes into the business by the end of the year.

Payback is the amount of time that it takes for investment to be repaid.

Question

For the following two projects, calculate the payback period. Recommend which project to choose.

Project A Project B

EOY 0 -100 -100

EOY 1 20 35

EOY 2 25 35

E0Y 3 35 30

EOY 4 25 15

EOY 5 25 10

Cash Flow ($000)

Question

Calculate the payback for an investment costing $100,000, which earns cash flows of:

$

EOY 1 10,000

EOY 2 20,000

E0Y 3 50,000

EOY 4 60,000

EOY 5 60,000

Complicated Cash Flows

Years Cash Flow Cumulative Cash Flow

EOY 0 -29,700 -29,700

EOY 1 11,300 - 18,400

E0Y 2 12,900 -5,500

EOY 3 15,200 9,700

EOY 4 10,400 20,100

EOY 5 5,100 25,200

The Payback period will be by the end of year 3, that is, when the cumulative cash flow is positive

The Payback period will be by the end of year 3, that is, when the cumulative cash flow is positive

Timing of the Cash Flow

Years Project A Project B

EOY 0 -12,000 -12,000

EOY 1 4,000 6,000

E0Y 2 4,000 3,000

EOY 3 4,000 3,000

EOY 4 4,000 3,000

EOY 5 4,000 3,000

Note: Both projects have the same payback but in different ways. If a business is attempting to decide between two projects, it may choose B on the grounds that the earlier cash flows occur in 1 year. This could be very significant to the liquidity position of the business. However, no account is taken of any cash flow after the payback period.

Although according to the payback method, projects have the same payback, the cash flow after the payback period makes Project A more attractive.

Note: Both projects have the same payback but in different ways. If a business is attempting to decide between two projects, it may choose B on the grounds that the earlier cash flows occur in 1 year. This could be very significant to the liquidity position of the business. However, no account is taken of any cash flow after the payback period.

Although according to the payback method, projects have the same payback, the cash flow after the payback period makes Project A more attractive.

QuestionEach of the projects involves a cost of 1 million dollars, but produces a net cash

flow as shown:

Years Project A Project B Project C

EOY 1 0 0.5 0

E0Y 2 0.5 0.5 0

EOY 3 0.5 0 0.5

EOY 4 0.5 0 1

EOY 5 0.5 0 1

1. Using a payback rule of:

a) two years

b) three years

Which projects are worth while?

2. Rank the projects in terms of payback period.

Advantages and Disadvantages of the Payback Method

Advantages Its simple to use. Its easy to understand. It’s the appropriate method to

use if there is concern over liquidity problems.

It’s a useful initial ‘test’ as to the validity of an investment.

It’s a valuable assessment of the risk involved.

Advantages Its simple to use. Its easy to understand. It’s the appropriate method to

use if there is concern over liquidity problems.

It’s a useful initial ‘test’ as to the validity of an investment.

It’s a valuable assessment of the risk involved.

Disadvantages Payback fails to take into

account any of the cash flows after the payback period.

It takes no account of the value of money over time.

It does not consider the profitability of the investment.

Disadvantages Payback fails to take into

account any of the cash flows after the payback period.

It takes no account of the value of money over time.

It does not consider the profitability of the investment.

There is therefore a need to find a method of calculating a more realistic value for the likely return on the proposed investment.

The Accounting Rate of Return - ARR

Unlike payback, ARR does take into account the rate of return over the whole life of the asset.

It expresses the annual increase in profit from the investment as a percentage of the capital cost. Measures profitability as a rate of return on investment.

This technique also avoids the danger of just selecting the investment which yields the highest cash inflows without taking into consideration the percentage return on the investment.

It is calculated by finding the percentage of the investment that the profit gained represents.

Steps in calculating the ARR – An Example$

EOY 0 (20,000)

EOY 1 10,000

E0Y 2 12,000

EOY 3 13,000

Cash Flow

Step 1: Calculate the Total Cash Flow = $ 35,000

Step 2: Calculate Profit $35,000 - $20,000 = $15,000

Step 3: Calculate Average Profit $15,000/3 years = $5000

Step 4: Divide Average Profit by Initial Investment = $5000/$20,000

ARR = 25%

It is the average profit which is divided by the value of the investment to give a return figure

Note: Whether this rate of return is an acceptable level will be dependent upon the targets set by individual businesses.

A worked Example

Cash Flow Project A($) Project B($)

EOY 0 - 10,000 - 18,000

EOY 1 3,000 6,000

EOY 2 6,000 9,000

EOY 3 7,000 12,000

Total Cash inflow 16,000 27,000

Total Profit (minus investment) 6,000 9,000

Average Profit 2,000 3,000

ARR 20% 16.7%

ARR(%) = Net Return (Profit) per annum

Capital Outlay (Cost)

Problem

Year Project A ($) Project B($)

EOY 0 -100,000 -100,000

EOY 1 20,000 35,000

EOY 2 25,000 35,000

EOY 3 35,000 30,000

EOY 4 25,000 15,000

EOY 5 25,000 10,000

Using the information contained in the table below, calculate the ARR, showing all your workings for both projects. Which project is most viable? Justify your answer.

Advantages and Disadvantages of ARR

AdvantagesIt takes into consideration all cash flows throughout the life of the investment.

It gives an indication of both the cash flows and profitability of the investment.

AdvantagesIt takes into consideration all cash flows throughout the life of the investment.

It gives an indication of both the cash flows and profitability of the investment.

DisadvantagesIt takes no account of when the cash flows occurs.

It takes no account of the consequences of time upon the value of money.

DisadvantagesIt takes no account of when the cash flows occurs.

It takes no account of the consequences of time upon the value of money.

Mini Case Studies

Question 3

Source: Jones, Hall, Raffo. Business Studies, 3rd Edition, Unit 50, page 354

Question 4

Source: Barratt and Mottershead. AS and A Level Business Studies, Unit 39, page 450-451

Activity 1

Source: Stimpson. AS and A Level Business Studies, Unit 5, page 450

The Discounted Cash Flow or Net Present Value - NPV

This method takes into account the value of money over time and it is therefore, a more realistic appraisal method.

It deals with the problem of interest rates and time.

It concentrates on the timing of cash flow and allows an estimation as to the likelihood of the investment being profitable.

Note: It is founded on the principle that return on investment project is always in the future and money paid or earned in the future is worth less today.

A fixed sum paid in the future is less than a fixed sum today.

The Discounted Cash Flow or Net Present Value - NPV

The value today of a sum of money available in the future is called the Present Value

Present Value (PV) = A ( 1+r) 100 Where: A = Amount of Money r = Rate of interest n = Number of years

Question: What is the present value of $100 in 3 years? Assume an interest rate of 10%

Answer: $75.13. This means that the $100 received in 3 years time is worth less than $100 today.

n

Discounting – How it is doneThe Present Value of a future sum of money depends on two factors:

1. The higher the interest rate, the less value cash has in today’s money.

2. The longer into the future cash is received, the less value it has today.

These two variables, interest rate and time are used to calculate discount factors. These are found in the DCF table.

Discounting is the process of reducing the value of future cash flows to give their value in today’s terms.

The worth of future cash when compared to today’s money depends on the rate of interest prevailing at the time.

DCF – takes into account that interest rates affect the value of future income. It shows that future cash flows is discounted by the rate of interest.

Using the DCF to determine Present Value

To use the Discount Factor to obtain Present Values of future cash flows, multiply the appropriate Discount Factor by the cash flow.

For example if $3,000 is expected in three years’ time. The prevailing rate of interest is 10%. The discount factor to be used is 0.75 – this means that $ 1.00 received in three years time is worth the same as 75 cents today. This Discount Factor is multiplied by $ 3,000 and the Present Value is $ 2, 250

Question

A business is considering investing $10,000 in the purchase of a new machinery. The following cash inflows are expected:

Year 1 $ 4,000

Year 2 $ 5,000

Year 3 $ 3,000

Year 4 $ 2,000

The discount rate used by the firm is 8%. It wants to know if the present day returns of the project discounted at 8% exceeds the present-day cost.

SolutionYear Cash Flow Discount Factor ( 8%) Discounted Cash

Flow

0 ($10,000) 1 ($10,000)

1 $5,000 0.93 $4,650

2 $4,000 0.86 $3,440

3 $3,000 0.79 $2,370

4 $2,000 0.74 $1,480

The Net Present Value is now calculated

NPV = Total DCF – Initial Cost of Investment

In the example, this gives:

Total Discounted Cash Flows $ 11, 940

Less Investment Outlay $ 10,000

NPV $ 1,940

This project is viable at a discount rate of 8% because the NPV is positive.

Exercise

Using the data presented in the solution, recalculate the Net Present Value at a discounted rate of 16%.

1. Why is the Net Present Value negative? (2marks)

2. Would the project be viable if the business had to borrow finance at 16% (2marks)

3. If the criterion rate used by the business for new investment is 10%, would this project have a positive Net Present Value, and would it therefore, be acceptable? (6 marks)

NoteThe choice of discount rate is, therefore, crucial to the assessment of

projects using this method of appraisal.

Usually, businesses will choose a rate of discount that reflects the cost of borrowing the capital to finance the investment. Even if the finance is raised internally, the rate of interest should still be used to discount future returns. This is because of the opportunity cost of internal finance – it could be used to gain prevailing rate of interest if left o deposit in the bank.

An alternative approach to selecting the discount rate is to be use for business is to adopt a cut-off or criterion rate. The business would use this to discount returns on projects and, if the NPV is positive the project will go ahead.

Advantages and Disadvantages of NPV

Advantages It considers both the timing of

cash flows and size of them in arriving at an appraisal.

The rate of discount can be varied to allow for different economic circumstances.

It considers the time value of money and takes opportunity costs into account.

Advantages It considers both the timing of

cash flows and size of them in arriving at an appraisal.

The rate of discount can be varied to allow for different economic circumstances.

It considers the time value of money and takes opportunity costs into account.

Disadvantages It reasonably complex to calculate

and to explain.

The final results depends heavily on the rate of discount used and expectations about interest rates may be inaccurate.

Net Present Value can be compared with other projects

Disadvantages It reasonably complex to calculate

and to explain.

The final results depends heavily on the rate of discount used and expectations about interest rates may be inaccurate.

Net Present Value can be compared with other projects

Exercisea. In appraising a $300,000 investment project, a firm uses a

discount rate of 10% percent. The equipment will produce a return (net of operating cost) of $ 100,000 per year over five years. At the end of the five years, the firm expects to sell the equipment for $10,000.

Calculate the net present value of this project.

b. After completing the above project appraisal at 10% rate, recalculate the Net Present Values using a discount rate of:

i. 20%; and

ii. 8%

What conclusions can you draw?

Exercise1. A business which manufactures soft drinks is considering three projects:

A. Several new labour-saving machines.

B. A new marketing campaign

C. Buying a small packaging business

From the table below, calculate: Payback, ARR and NPV at 10 (16 marks)

Period Project A ($) Project B($) Project C($)

EOY 0 - 100,000 -100,000 - 100,000

EOY 1 30,000 35,000 10,000

EOY 2 32,000 35,000 30,000

EOY 3 35,000 30,000 40,000

EOY 4 25,000 15,000 30,000

EOY 5 10,000 10,000 25,000

2. Advise the business at to the best option, on financial grounds only.(5marks)

3. Suggest the non-financial factors that would influence your final decision. (5marks)

The Internal Rate of Return - IRR

The IRR is that rate of discount which yields a Net Present Value of Zero. This rate of discount is then compared with:

The IRR of other projects – the highest reflects the most profitable investment.

The expected cost of capital or rate of interest. A cut – off rate of return preset by the business.

The discount rate where the NPV = 0 is where the sum of the Present Value is exactly equal to the capital cost of the project.

If the IRR exceeds the market rate of interest (which has to be paid to secure the funds) then the project is worth while. If the IRR is less than the interest rate charged, then the project should be rejected.

The Internal Rate of Return - IRR

Its basically the rate of return the project is forecasted to achieve minus the rate of inflation.

For example, if a business wants a 20% return on capital invested (in real terms) NPV will give an indication of whether or not the project has achieved that level of return.

The IRR, on the other hand, tells the business exactly what returns a project is forecasted to achieve.

ExercisePeriod Actual Cash

FlowDCF @ 8% DCF@ 12% DCF@ 20%

EOY 0 (35,000) (35,000) (35,000) (35,000)

EOY 1 15,000 13,000 13,350 12,450

EOY 2 15,000 12,900 12,000 10,350

EOY 3 10,000 7,900 7,100 5,800

EOY 4 10,000 7,400 6,400 4,800

Net Present Value 7,150 3,850 (1,600)

0

1000

500

-1000

-500

5 10 15 20

Criterion Rate

% Discount Rate

IRR%

Net Present Value as a function of Discount Rate

Case Presentations

Cases

1. King and Green Ltd – Stimpson, page 445-446

2. Investing to stay competitive – Stimpson, page 456 – 457

3. Mini- Case – Shift it Limited – Barratt and Mottershead, page 456

4. Parkinson & Co – Jones, Hall, Raffo, page 358

Reading Task

Title: Qualitative Factors – investment decisions are not just about profit

Source: Stimpson Peter. AS and A Level Business Studies, Unit 5, pages 450-451

Other Factors influencing investment decisions

ETHICAL CONSIDERATIONS

HUMAN RELATIONS

CORPORATE STRATEGY

AVAILABILITY OF FUNDING

CURRENT CASH FLOW

BIBLIOGRAPHY1.Barratt Michael and Mottershead Andy. AS and A Level Business Studies, Pearson

Education Ltd,2000.

2.Jewell Bruce. An Integrated Approach to Business Studies, 4th Edition, Pearson Education Ltd 2000.

3. Hall Dave, Jones Rob, Raffo Carlo. Business Studies, 3rd Edition, Causeway Press Ltd, 2004.

4. Stimpson Peter. AS and A Level Business Studies, Cambridge University Press, 2000.

www.bized.ac.uk

END OF UNIT