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3.2 Investment Appraisal

3.2 Investment Appraisal. Chapter 19. Investment. To purchase capital goods Equipment Vehicles New buildings Improving existing fixed assets. Investment Appraisal. Evaluating the profitability or desirability of an investment project

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3.2 Investment Appraisal

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  1. 3.2 Investment Appraisal Chapter 19

  2. Investment • To purchase capital goods • Equipment • Vehicles • New buildings • Improving existing fixed assets

  3. Investment Appraisal • Evaluating the profitability or desirability of an investment project • Quantitative Investment AppraisalUsing techniques to study the financial issues of investment (think Qty-$$$) • Qualitative AppraisalStudying non-financial issues that may impact an investment decision (think Quality)

  4. Quantitative Investment Appraisal • Requires the following information: • Initial cost of investment (including installation) • Estimated life expectancy (how many years can returns be expected from the investment) • Residual value (at the end of its useful life, can the asset be sold for additional $$) • Forecasted net returns or net cash flows from the project (money generated from the investment minus the annual running cost)

  5. Quantitative Investment AppraisalTwo Methods • Payback PeriodLength of time required for net cash flows to pay back the original capital cost of the investment • Average Rate of ReturnAnnual profitability of an investment as a percentage of the initial investment

  6. Forecasting Cash Flows • Cash Inflow Annual Revenuesminus • Cash Outflow Annual Operating Costs • = Net Cash Flow • Problems occur when forecasting the future because no one can predict what external forces will effect cash flows. • This can make cash flow projections inaccurate. Manager must take this into consideration.

  7. Why is there uncertainty here? • A project to construct a factory to make large and expensive luxury cars • An investment in a new computerized banking system offering customers new services using state-of-the-art equipment that has not yet been thoroughly tested.

  8. Why is there uncertainty here? • Cash-flow forecasts for a new sports center that are based on a small market research sample. • The building of a new toll motorway between two cities. • The construction of an oil-fired power station.

  9. Projects in Charlotte? • Can you name projects that were successful or did not meet projected goals?

  10. Payback Method • Length of time required for net cash inflows to pay back the original capital investment. • Managers compare the payback period to alternative projects to put them in priority order.

  11. Payback Method-Considerations to Evaluate • A business could borrow the investment money….longer payback time means more interest payments. • Opportunity cost of money – what other projects could be funded. • The longer the payback period the more likely external factors could be a problem and are likely unpredictable. • Managers can be “risk averse” – faster payback is less risky by reducing uncertainty • Long payback can reduce the value of money by inflation.

  12. Average Rate of Return (ARR) • Measures the annual profitability of an investment as a percentage of the initial investment. Annual Profit (Net Cash Flow) Initial Capital Cost ARR% = X 100

  13. Why is ARR Important? • You can compare ARR on multiple projects. • Criterion Rate – a company may only accept projects that meet or exceed a certain ARR Rate…say 15% or more. • Annual interest rate on loans needs to be considered….if the ARR is 5% and the interest rate on money to fund the project is 12%, it is not worth making the investment

  14. Qualitative Investment Appraisal • Studying non-financial issues that may impact an investment decision • Impact on the environment • Bad publicity could harm company image and reduce sales • Planning permission may not be granted or be hindered by pressure groups • Aims and objectives of the business may be in opposition with project (a commitment to personalized customer service might hinder a project to computerize services) • Risk….No amount of positive data can alter some management decisions they feel are unwise.

  15. Qualitative Investment Appraisal • Can you think of projects that were “shelved” because of qualitative reasons? • We make simple qualitative and quantitative decisions every day. • How can you apply quantitative or qualitative appraisal to your life?

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