Chapter 29- investment appraisal

Question 1

Investment appraisal

Answer 1

• how a business can decide whether to undertake a particular capital investment such as building a new factory or buying an additional machine

Question 2

Should a business invest?

Answer 2

• business needs to establish whether the investment is appropriate or worthwhile
• it will have to consider the level of risk involved, how quickly the investment will pay for itself, and whether the investment will be profitable

Question 3

Investments can include a range of activities or products such as:

Answer 3

• purchase of machines
• building extensions or new factories
• buying another business (acquisitions)
• undertaking a large marketing campaign

Question 4

Investment appraisal techniques

Answer 4

• they are quantifiable methods of deciding if an investment should go ahead

Question 5

What are the 3 methods of investment appraisal?

Answer 5

1. Payback
2. Accounting rate of return (annual average rate of return)
3. Net present value

Question 6

Payback

Answer 6

• this technique measures how quickly the cost of the investment can be paid back
• the faster the payback the better the investment
• payback is sometimes seen as a way of measuring the amount of risk involved
• the longer the payback period the greater is the degree of risk involved
• this technique is often the first to be applied because the length of time for the investment costs to be covered (paid back) is regarded as a more important factor at this stage, then the level of profit it may yield in the longer term
• payback can be used to assess the viability of a given investment and to compare alternative investments

Question 7

Payback terminology

Answer 7

EOY- end of year
EOY 0- a nought is added to indicate the year when the investment takes place
EOY 1- one year after the investment
Net cash inflow- the likely return on an investment in a given year
To calculate the net cash inflow: revenue - direct costs
Cumulative cash flow- the net amount of cash taking into consideration the initial investment and the net cash inflows

Question 8

Example (payback)

Answer 8

Year Net cash inflow.Cumulative cash (if)
Eoy0. (150,000)
Eoy1 50,000. (100,000)
Eoy2. 40,000. (60,000)
Eoy3. 40,000. (20,000)
Eoy4. 30,000. (10,000)

Payback occurs within 4 years
Necessary to look at how much is still to be paid in the cumulative cash’s inflow from the previous year (20,000) and the amount of the net cash inflow for the next year (30,000)
20,000/30,000=0.66 x 12= 7.92 = 8 months
3 years and 8 months is the payback
Days= 20,000/30,000= 0.66 x 365= 243.3 days

Question 9

Advantages of payback period

Answer 9

• easy to calculate and understand and is therefore a cost-effective way of assessing an investment
• it is a quick and useful guide to the level of risk involved in an investment, the longer the payback the greater the risk
• because payback puts an emphasis on how quickly an investment is paid back it is an effective method for companies in markets which are constantly changing

Question 10

Disadvantages of payback method

Answer 10

• it ignore the value of money over a period of time; the purchasing power of money falls as price rises. Inflation erodes the spending power of money
• it does not take into consideration any cash inflows after the payback period
• there is no indication of when within nay given year the cash inflows will occur
• it does not measure the level of profits from the investment

Question 11

Accounting rate of return (ARR)

Answer 11

• This method of investment appraisal measures the profitability of any investment
• The profit is expressed as a percentage of the cost of the investment
• by taking the annual average return, this method also takes into consideration the life of the investment unlike payback
• the higher the rate of return the better is the investment
• alternatively another any to judge the success of the investment is by comparing the rate of return with the interest rates within the economy
• if the percentage rate of return covers the percentage interest rates then the investment may be seen as worthwhile
• the rate of return may need to be higher than the rate set out in the objectives of the business

Question 12

Example (accounting rate of return)

Answer 12

An investment in a new digital printing machine which lasts for five years costs 15,000. The cash inflows (revenue-direct costs) from this printer are shown in table 29.5

Year. Cash inflows
Eoy0. (15,000)
Eoy1. 10,000
Eoy2. 11,000
Eoy3. 13,000
Eoy4. 15,000
Eoy5. 11,000

1. Total cash (eoy1 to 5) inflows=60,000
2. Total cash inflows- cost of investment= profit 60,000-15,000=45,000
3. Average annual profit (profit/life of printer (5 years)
   (45,000/5)= 9000
4. Return on investment= annual average profit/ cost of investment
   (9000/15,000= 60%

Question 13

Advantages of ARR

Answer 13

• It takes into account all of the cash flows throughout the life of the investment
• it measures the profitability of the investment
• it is relatively easy to calculate and understand
• it allows for a simple comparison between two or more investment opportunities or the opportunity cost of the investment

Question 14

Disadvantages of ARR

Answer 14

• There is no indication of when the cash inflows occur within any given year
• it ignores the value of money over time. The purchasing power of money falls as prices rise
• the life of the investment needs to be known and may alter over time
• it is harder to calculate than the payback and therefore will cost more in time and money to appraise potential investments

Question 15

Opportunity costs

Answer 15

• consideration of the next best alternative that money could have been used for

Question 16

Net present value

Answer 16

• in order to gain a realistic measure of any investment the net present value (NPV) method needs to be used
• this method of investment appraisal considers the value of money over time
• it converts all monetary values into todays values to allow for a realistic assessment of the returns in the years ahead
• this method works on the assumption that any inflows will be worth less than the same amount today
• the technique discounts the value of money over time by a given percentage rate
• the discounted rate allows the calculation of the discounted cash flow (dcf)

Question 17

What will the actual percentage discount rate depend mainly on?

Answer 17

The level of inflation within an economy

Question 18

Other factors which affect the discount rate to be used are:

Answer 18

• opportunity cost: the return on the investment must be better than the next best alternative
• some discount rates are determined by the business itself.
• the length of the investment may also be a consideration. The longer the life of the investment the higher the discount factor in order to take account of the fall in the value of money over a period of time
• the amount of risk: if an investment is riskier, the required return will increase and therefore be reflected in the discount rate (higher)

Question 19

How do you work out present value?

Answer 19

Net return x discount factor

Question 20

Example (net present value)

Answer 20

Year net return discount. Present value
0. (10,000). 1. 10,000
1. 4300. 0.952. 4093.6
2. 3100. 0.907. 2811.7
3. 2650. 0.864. 2289.6
4. 1850. 0.823. 1522.5
Total 1900. 10,717.4- 10,000=717.4
(Returns
-cost)
Original figure of 1900 after the discounted factor of 5% is now only 717.40
Net present value is still positive and is therefore considered worthwhile

Question 21

With a negative answer the investment is?

Answer 21

Not worthwile
- this means that the cost of the investment takes place immediately, the returns from the investment (inflows) come in over four years and during this period of time the value of money is being eroded so much so that in todays values the investment will not cover its costs

Question 22

The higher the discount factors the greater the?

Answer 22

Returns need to be to cover the falling value of money

Question 23

Advantages of net present value

Answer 23

• it takes account of the value of money over time
• all cash inflows are accounted for (not so for payback)

Question 24

Disadvantages of net present value

Answer 24

• it is more complicated to work out than payback and ARR
• because it is more complicated, it takes longer to make a decision and is therefore more expensive
• its value as a decision making tool is limited by the selection of the discount factor which is at best only an educated guess about the value of money over time

Question 25

Non-financial factors affecting investment decisions (qualitative): objectives of the business

Answer 25

1. Resources available, productive capacity, labour, finance - the business may not have the required labour to operate the new machine - a significant amount of training may be required that would be too costly when added to the cost of buying the machine 2. The economy - level of inflation may affect the discount factor used - if the economy is moving towards a recession there may be insufficient demand in the future to justify the investment 3. Value of different currencies can fluctuate daily

Question 26

Internal rate of return

Answer 26

- net present value doesn’t yield any specific information on the actual return on the investment - internal rate of return is a method of investment appraisal that does allow the return to be calculated - the net present values are used in determining the internal rate of return To calculate the DCF- cash flow x discount factor To calculate NPV- add the DCF for each of the years then - the initial investment

Question 27

Methods of calculation

Answer 27

- 2 discount factors are used - the first where a positive net present value is produced and the second where a negative net present value is produced - using two discount factors and therefore having two net present values, one positive and one negative means that a discount factor that produces a net present value of nought (0) is found - the net present value of 0 means that this is is fact the rate of return on the project in question Internal rate of return can be fond by plotting the NPVs on to a graph Positive NPV is plotted above the line of the discount factor Negative NPV is plotted below the discount factor line The point where the line cuts the discount factor line (where the NPV is 0) represents the approximate return on the investment

Question 28

Internal rate of return

Answer 28

The discount rate at which the NPV is equal to zero