3.8 Investment Appraisal

define the following terms: (AO1)
- payback period
- average rate of return
- net present value
- discount rate
calculate, compare and evaluate investment opportunities using the payback period (AO3, AO4)
calculate, compare and evaluate investment opportunities using the average rate of return (ARR) (AO3, AO4)
calculate, compare and evaluate investment opportunities using the net present value (NPV) (AO3, AO4)

3.8 Quizlet

https://quizlet.com/_d44lkk?x=1qqt&i=4jrhob

https://www.gimkit.com/view/64399fea088a7300328749bf

Accounting rate of return (ARR)

Also referred to as the average rate of return, this method of investment appraisal calculates the average annual profit of an investment project expressed as a percentage of the amount of invested.

Capital expenditure

A business organization’s spending on the purchase or acquisition of fixed assets, e.g. spending on buildings (premises), machinery, equipment and tools.

Cumulative net cash flow

The sum of an investment project’s net cash flows for a particular year plus the net cash flows of all previous years.

Discount rate

Also known as a discount factor, this is the figure used to reduce the future value of money. It is used to establish the present value of cash that is yet to be received by the business.

Discounted cash flow

This method of investment appraisal uses a discount rate (the inverse of compound interest) to reduce the value of money received in future years because money loses its value over time.

Investment

Capital expenditure with the intention of a financial return on this spending at some point in the future.

Investment appraisal

The formal process of quantifying the financial risks of an investment decision, in order to establish whether the expenditure can be justified from a financial perspective.

Net present value (NPV)

A method of investment appraisal that calculates the real value (rather than the absolute value) of an investment project by discounting (adjusting) the actual value of money received in the future.

Payback period (PBP)

The investment appraisal method that considers the time it takes for the amount of money invested in a project to be repaid using the proceeds generated from the investment.

Principal

The principal refers to the capital outlay or the original amount spent on an investment project.

Qualitative investment appraisal

Method of investment appraisal used to determine whether a project is worth investing in by using non-numerical techniques, e.g., whether the project aligns with the organization’s mission.

Quantitative investment appraisal

Method of investment appraisal used to determine whether an investment project is worthwhile based on financial analysis, namely, PBP, ARR, and NPV.

3.8 Powerpoint

3.8 Investment Appraisal

https://docs.google.com/presentation/d/1wzHEfDy_DGUrOG__W697Obh6RRp5Jd-zcBCl93r_GJ8/edit?usp=sharing

3.8 Investment appraisal IBID

https://docs.google.com/presentation/d/1XVIQhxkXnnOIdwWlo4XKg2Ededo1y2v5NwX6Bg38Vm0/edit?usp=sharing

3.8 Extra Notes

Investment

Investment refers to the capital expenditure of a business (i.e. the purchase of fixed assets or a business venture) with the intention of a financial return on the investment in the future.

The essential questions that managers need to ask regarding any investment are:

Cost: What are the financial costs of the investment?
Time: How long will it take to pay for the investment and for the investment to start earning a profit?
Opportunity Cost / Alternatives: What are the opportunity costs of this investment?
Risk: How risky is this investment

Investment opportunities using payback period (AO3 and AO4)

Payback Period (not in Formula Booklet)

Payback period (PBP) is the length of time required for an investment to recover its initial cost of investment (principal) in terms of profit.

Step 1: Calculate the Net Cash Flows and then the Cumulative Net Cash Flows each year

Step 2: Find when the Cumulative Net CF becomes positive and then the amount left to pay the year before that.

Step 3: Calculate the Payback Period

Above Example: Cumulative net cash flow becomes positive in year 3. Therefore the investment is paid off between years 2 and 3.

Find the amount left to pay in the year before the cumulative net CF becomes positive

Year 2 Amount left to Pay: $60 000

Net CF the year the Cumulative Net Cash Flow becomes positive: $120 000

Calculate:

Payback period = 2 years and 6 months

Payback Period Example

A pizza restaurant is now considering purchasing a pizza oven that is worth $5,000.

It’s expected to generate the following net cash flows in the first four years: $3,000, $1,500, $1,500 and $1,000.

Calculate the Payback Period for the pizza oven.

Step 1: Calculate the Net Cash Flows and then the Cumulative Net Cash Flows each year

Note: negative numbers are in brackets

Year 1 Cumulative Net CF: -5000 + 3000 = -2000

Year 2 Cumulative Net CF: -2000 + 1500 = -500

Year 3 Cumulative Net CF: -500 + 1500 = 1000

Step 2: Find when the Cumulative Net CF becomes positive and then the amount left to pay the year before that.

In Year 3 the Cumulative Net CF become positive. Therefore the project is paid off sometime between year 2 and 3.

Step 3: Calculate the Payback Period

Find the annual net CF of the year that project is paid off (year 3 in thise case) and divide it by the amount of money left to pay off ($500 left to pay after year 2).

Annual Net CF of Year 3 = $1500

Amount left to pay after Year 2 = $500

(500 / 1500) * 12 months = 4 months

The payback period is therefore:

2 years and 4 months.

Advantages of Payback Period

Simplicity: The payback period is straightforward to understand and easy to calculate, making it useful for quick assessments and comparisons between projects.
Risk assessment: The payback period helps in assessing the risk of an investment. Projects with shorter payback periods are generally considered less risky than those with longer payback periods, as the initial investment is recovered more quickly.
Liquidity focus: The payback period emphasizes liquidity as it is concerned with cash inflows. This can be important for businesses where cash flow management is critical.
Suitability for small businesses: Due to its simplicity, the payback period is particularly suitable for small businesses or for projects where the exact estimation of cash inflows in future years is challenging.
Useful for industries with rapid technological change: In industries where technologies change rapidly (like IT or electronics), the payback period can be a useful measure as it doesn't consider returns after the payback period, which may be more uncertain

Limitations of Payback Period

Ignores the long-term profitability of an investment
- A more desirable investment may be overlooked as it has a longer payback period
Only relies on cash flow forecasts, which are estimates.
Ignores Time Value of Money: Assumes that future cash flows have the same value as those of today, however inflation reduces the value of money.
Ignores Qualitative investment considerations

Investment Appraisal Payback Tutorial

https://youtu.be/Sw9RLOMNP7o?si=MTj0J4GYl-Ackbuq

Investment opportunities using average rate of return (ARR) (AO3 and AO4)

ARR (Average Rate of Return)

Average rate of return (ARR) is average profit on investment expressed as a percentage of the initial investment (capital costs).

If PBP shows time, then ARR shows percentage.
After calculating ARR, managers usually compare it to other investments, but also to the interest rate in the banks.
- - Depositing money in a bank has almost no risk, but pursuing an investment project is quite a risky thing to do.
Many companies develop their own benchmarks for ARR (called criterion rate) that are used to assess the viability of different investment opportunities.
- - Example: Some companies will only invest in projects with a minimum ARR of 10%. Depends on the company and industry though!

ARR = (total returns – capital costs) ÷ years of use ÷ capital costs ⨉ 100

ARR Example

A pizza restaurant is now considering purchasing a pizza oven that is worth $5,000.

It’s expected to generate the following net cash flows in the first five years: $3,000, $2,500, $2,000, $1,500, and $1,000.

Calculate the ARR for the pizza oven.

Advantages of ARR

Simple Calculation: ARR is a straightforward method for assessing investment profitability. It involves dividing the average annual profit by the initial investment.
Easy Comparison: ARR allows for easy comparison between different investment projects. It helps managers quickly determine the expected rate of return for each project and make informed decisions.
Comparison to Minimum Required Return: ARR can be compared to the minimum required return for a project. If the ARR is lower than the required return, it indicates that the project may not be worthwhile.
Accounts for Profitability for the entire lifespan: Payback period only considers cash flows until the investment pays off, whereas ARR considers all cash flows for the entire project.

Limitations of ARR

Ignores Time Value of Money: ARR does not consider the time value of money. It does not account for the fact that money available in the present is worth more than the same amount in the future due to its potential earning capacity.
Ignores Cash Flow Timing: ARR does not take into account the timing of cash flows. It does not consider the impact of uneven revenue streams, the lack of cash flow in the early years of a project, or if the project makes a large profit in the long term compared to the short term.
Does Not Account for Long-Term Risk: ARR does not factor in the increased risk associated with long-term projects. It does not consider the uncertainty and potential challenges that may arise over extended periods.
Based on estimates: The longer the investment project under consideration, the less accurate the forecasts will be; we might know what we have planned to do tomorrow or next week, but less certain about this for 5 or 10 years' time.

Investment Appraisal ARR Tutorial

https://youtu.be/0znLotQ0IVU?si=v5keaYIYI-zZijyL

Investment opportunities using net present value (HL only) (AO3 and AO4)

NPV (Net Present Value)

NPV is a method of making investment appraisals more accurate by using a discount rate to adjust the value of future returns.

NPV = Sum of present values – Original cost

Present value (single year) = net cash flow x discount factor

Net Present Value (NPV) is a financial concept used in capital budgeting and investment analysis to determine the profitability of a project or investment. It measures the difference between the present value of cash inflows and the present value of cash outflows over a specific period of time.

NPV takes into account the time value of money, which means that a dollar received in the future is worth less than a dollar received today.

To calculate NPV, you need to estimate the timing and amount of future cash flows and select a discount rate, which is typically the minimum acceptable rate of return.

Positive NPV: A positive NPV indicates that the projected earnings from a project or investment, when discounted to their present value, exceed the anticipated costs. It suggests that the investment is expected to be profitable and creates value.
Negative NPV: A negative NPV indicates that the projected earnings are lower than the anticipated costs, resulting in a net loss. Investments with negative NPV are generally considered unfavorable and may not be undertaken.

Comparison and Decision Making: NPV can be used to compare the rates of return of different projects or to compare a projected rate of return with the hurdle rate required to approve an investment. It helps in evaluating the profitability and feasibility of investment opportunities.

NPV Example

A pizza restaurant is now considering purchasing a pizza oven that is worth $5,000.

It’s expected to generate the following net cash flows in the first five years: $3,000, $2,500, $2,000, $1,500, and $1,000.

Calculate the NPV for the pizza oven using a 6% discount rate.

NPV = Sum of present values – Original cost

Present value (single year) = net cash flow x discount factor

Present values are calculated by multiplying the Net Cash flow by the discount factor for the relevant year (discount factors are provided in the exam and can be found below).

Discount Table

Advantages of NPV

Time Value of Money: NPV considers the time value of money by discounting future cash flows to their present value. It recognizes that a dollar received in the future is worth less than a dollar received today.

Better Decision Making: NPV helps in making better investment decisions by providing a clear measure of profitability. It allows for comparing different investment options and selecting the one with the highest NPV.

Incorporates All Cash Flows: NPV takes into account all cash flows associated with an investment, including initial investment and future cash inflows and outflows. It provides a comprehensive view of the investment's financial impact.

Considers Risk: NPV allows for adjusting the discount rate to reflect the riskiness of the investment. It provides a more accurate assessment of the investment's potential returns by incorporating risk into the calculation.

Limitations of NPV

Requires Accurate Cash Flow Projections: NPV relies on accurate estimation of future cash flows. If the projections are incorrect or unrealistic, it can lead to inaccurate NPV calculations and flawed investment decisions.
Subjectivity in Discount Rate Selection: The selection of an appropriate discount rate is subjective and can vary among individuals or organizations. Different discount rates can lead to different NPV results and potentially conflicting investment decisions.
Ignores Non-Monetary Factors: NPV focuses solely on financial aspects and does not consider non-monetary factors such as environmental impact or social benefits . It may overlook important qualitative aspects of an investment.
Complex Calculation: NPV involves complex calculations, especially for projects with multiple cash flows over an extended period. It requires a thorough understanding of financial concepts and may be challenging for individuals without financial expertise.

Discount Rate - What is it and how is it calculated?

💡 What is the Discount Rate?

The discount rate is the rate used to convert future cash flows into their present value.
It reflects the time value of money – the idea that money today is worth more than the same amount in the future.

🧠 Why is the Discount Rate Important in NPV?

It helps determine how valuable a project’s future cash flows are today.
A higher discount rate = lower present value of future cash flows.
A lower discount rate = higher present value of future cash flows.

🔍 How is the Discount Rate Decided?

🏦 Cost of Capital (Most common method)
- Often based on the Weighted Average Cost of Capital (WACC).
- WACC reflects the average return investors expect, combining cost of debt and cost of equity.
🎯 Required Rate of Return
- The minimum return a business expects from an investment.
- Set by management, based on company goals or benchmarks.
📉 Risk Level of the Project
- Riskier projects = higher discount rate.
- Safer, more predictable projects = lower discount rate.
🌍 Inflation and Economic Conditions
- If inflation is expected to rise, discount rates are adjusted higher.
- Interest rates in the economy can influence the discount rate too.