Investment Appraisal (05) Flashcards
(22 cards)
SUMMARY
In summary, the following are covered in this topic:
1. Investment appraisal is a process of using quantitative techniques that assess
the financial feasibility of a project.
2. Investment appraisal is important due to the large amount of company
resources used, opportunity cost, as well as the impact on shareholders’ wealth.
3. The risks in making investment decisions include the political climate, state of
economy, project duration and nature of market.
4. The investment appraisal techniques include payback, the average rate of
return and net present value.
5. Payback period records the time taken for the net cash inflows to pay back the
original capital cost of investment.
6. The average rate of return (ARR) measures the annual profitability of an
investment as a percentage of the initial investment.
7. Average rate of return considers the total return (yield) over the whole life of
the investment.
8. The net present value (NPV) measures today’s value of the estimated cash flows
resulting from an investment.
ARR(%) formula
ARR(%) = Annual profit (net cash flow) / Initial capital cost x 100
Year Net cashflow ($)
0 (20 000)
1 5 000
2 11 000
3 10 000
4 10 000
The steps to calculating ARR is as follows.
1 Add up all positive cash flows $5000 + 11 000 + $10 000 + $10 000
= $36 000
2 Subtract cost of investment $36 000 - $20 000 = $16 000
This is the total net cash flow
3 Divide by life span $16 000 / 4 = $4000
This is the annual profit or net cash flow
4 Calculate ARR using the formula $4000/ $20 000 x 100 = 20%
Advantages of ARR
Unlike the payback method, ARR considers the entire cash flows.
ARR focuses on profitability, which is a key objective for most businesses.
The result is easily understood and comparable with other investment projects
competing for the limited funds available.
The result can be quickly assessed against a predetermined criterion rate set by
the business.
Disadvantages of ARR
ARR ignores the timing of cash flows. This could result in two projects having
similar ARR results, but one could pay back much earlier than the other one.
As all cash inflows are included, the later cash flows, which are less likely to be
accurate, are included in the calculation.
The time value of money is ignored, as the cash flows have not been discounted.
Advantage of NPV
It considers both the timing and size of cash flows in the appraisal.
The discount rate could be varied to allow for changes in economic conditions.
It considers the time value of money and takes the opportunity cost of money
into account.
Disadvantages of NPV
It is reasonably complex to calculate and explain.
The NPV calculated depends on the discount rate used, and expectations about
interest rates may be inaccurate.
NPV can be compared with other projects, only if the initial cost of investment
is identical. This is because NPV does not provide a percentage rate of return on
the investment.
What is Investment Appraisal?
Investment appraisal is a process of using quantitative techniques to assess the
financial feasibility of a project.
Why is Investment Appraisal important?
1) Large amount of resources involved
Investments usually involve large amount of company resources and the management is responsibility in ensuring that the investment will bear good returns. In some cases, these expenditures are financed through bank loans that incur interest charges. Failed investments will likely result in banks suing the business if it fails to repay the loan.
2) Opportunity cost
As businesses face many choices to invest their funds, select one will mean forgoing another due to limited funds. As such, the management needs to use investment appraisal techniques to assess the different choices and select the one that gives the best returns for the business.
3) Maximise wealth of shareholders
One of the management’s objective is to maximise the wealth of shareholders. As such, the management needs to appraise the different investment options to select one that will give the best returns so that shareholders’ wealth is maximised. This will encourage both existing shareholders to continue investing in the business, and potential shareholders to start investing in the business.
What are the various risks in investment decisions?
1) Political climate
This refers to the state and stability of politics in the country of
investment. Countries that often experience political upheaval are riskier for
investments. This is because different political parties have different philosophies
towards governance. For example, the incumbent government may be pro-business
but the next may be anti-business. Thus, investing in such countries carries high risk.
2) Economic stability
Investments during periods of economic growth usually yield better returns. However, during periods
of economic downturn, investment decisions carry higher risks as there are less spending and banks are more conservative in approving loans. Banks may even recall loans, which may result in the foreclosure of businesses that are unable to repay the loan. However, businesses that are risk-taking and financially endowed may take advantage of the economic downturn to cement their market position by investing in growth projects. This is due to the availability of cheaper resources and competitors leaving the market.
3) Length of project
This refers to the life span of the investment. Different investments have different timelines. Projects that have a longer timeline carry higher risk as it is much harder to forecast returns accurately many years into the
future. Furthermore, tastes and preferences may change, or new competitors or products may enter the market.
4) Nature of market
This can refer to either how stable or competitive a market is. A stable market is one that has minimal growth fluctuations, as well as consistent low inflation. The more stable a market, the less risky would be the investment decision. The competitive nature of a market measures either the number of competitors in the market or the ease at which new competitors can enter the market, or both. The more competitive the nature of market, the more risky the investment decision would be.
What are the three investment appraisal techniques?
1) Payback
Payback period records the time taken for the net cash inflows to pay back the
original capital cost of investment.
2)
What is the formula to calculate the exact month for payback year?
Additional net cash inflow needed / annual cash flow in payback year * 12 months
What are the advantages of Payback?
The following are advantages of using payback method:
It is quick and easy to calculate, and managers can easily understand the results.
The emphasis on speed of return of cash flows gives the benefit of concentrating
on the more accurate short-term forecasts of the project’s profitability.
The result can be used to eliminate or ‘screen out’ projects that give returns too
far into the future.
It is particularly useful for businesses where liquidity is of greater significance
than overall profitability.
What are the disadvantages of Payback?
The following are disadvantages of using payback method:
It does not measure the overall profitability of a project. It ignores all of the cash
flows after the payback period. It may be possible for an investment to pay back
quickly, but then offer no further cash inflows.
This concentration on the short term may lead businesses to reject very
profitable investments just because they take some time to repay the capital.
It does not consider the timing of the cash flows during the payback period.
Evaluation of the usage of Payback
The payback method is often used as a quick check on the feasibility of a project or
as a means of comparing projects. However, it is rarely used in isolation from the
other investment appraisal methods.
What is Average Rate of Return (ARR)?
The average rate of return (ARR) measures the annual profitability of an investment
as a percentage of the initial investment.
Evaluation of ARR
ARR is a widely used method to appraise investments, but it is best considered together with payback results. This would allow the business to consider both profitability and liquidity.
What is Net Present Value (NPV)?
The net present value (NPV) measures today’s value of the estimated cash flows resulting from an investment.
It uses discounting, which is the process of reducing the value of future cash flows by calculating that value in today’s terms. Discounting calculates the present values of future cash flows so that different investment
projects can be compared by considering today’s value of their returns. A business would likely invest in the project that gives the highest NPV.
What is the formula for Discount Factor?
Discount factor = 1/(1+r)^n
where r = discount rate, n = time
What are the steps to calculate NPV?
refer to page 7
Evaluation of NPV
In general, NPV improves the decision-making process of the business. This is
because it considers the full duration of the projects of the same size.
What are the Qualitative factors in investment appraisal?
1) Impact on environment and community
Managers making investment decisions would need to consider the potential impact on the environment, such as whether it would result in pollution, or the impact on the community, such as whether it
would result in job losses. Any bad publicity due to the investment would affect the business negatively.
2) Business objectives and unique selling proposition (USP)
Managers in making investment decisions would need to consider the business objectives, as well as its
USP. If an investment results in automation, but the USP of the business is in customisation and providing excellent customer service, managers should not go ahead with the investment decision.
3) Risk averseness
Different managers are prepared to accept different degrees of
risk. If a manager is risk averse, no amount of positive quantitative data can
convince him to undertake an investment project.
