BUSINESS & MANAGEMENT

1. BUSINESS & MANAGEMENT Unit 3.2 Investment Appraisal 1/18

2. KEY TOPICS Standard Level • Quantitative investment appraisal methods: Accounting Rate of Return (ARR) and Payback Period (PBP) • Qualitative investment appraisal Higher Level Extension • Quantitative investment appraisal methods: Discounted Cash Flow (DCF) and Net Present Value (NPV) 2/18

3. DEFINITIONS • Principal - the money spent on an initial investment • Money is assumed to go down in purchasing power because of inflation. • Opportunity costs arise because money spent on buying capital goods is not being invested. • Quantitative investment appraisal - Only worries about money factors in investment • Qualitative investment appraisal looks at everything else. • Unit cost of production - how much it cost to make whatever the company is selling 3/18

4. Calculating Bank Interest • Formula: Interest = (Amount x Interest Rate) x Number of Years • Question 1: Mr. Mason puts 33000 Yuan in the bank for 3 years at a rate of 3.5%. How much interest will he make? • Question 2: Remi puts 2200 Canadian Dollars in the bank for 22 months at a rate of 2.3% per annum how much interest will he make? Interest = 33,000 x 0.035 x 3 = 3,465 Yuan Interest = 2,200 x 0.023 x 22/12 = C$ 92.7667 4/18

5. Investment Appraisal • Calculating the cost and potential gains from an investment. • Investment is the spending of money on assets that will have future financial gains. 5/18

6. Ways to help assess a financial decision • Payback Period- the amount of time it will take for profits from an investment to earn back the money that is spent on it. • Formula: (Initial Investment $$)/(Contribution per Time Frame) 6/18

7. Payback Period Considerations • Businesses look for the shortest payback periods when making decisions on investments. • When it comes to equipment, today’s businesses are careful that the payback period does not outlast the useful time frame (i.e. useful lifespan) of the equipment. • Obviously it can be very difficult to speculate on the future returns many years down the road. • Page 351 7/18

8. Work out the following estimation: • Darcy has a Penguin/ Monkey Land and he is thinking about expanding the area that the animals fight in. He estimates the cost to be 87 thousand dollars. His estimated increase in profits will be: • Year 1 5000 • Year 2 32000 • Year 3 40000 • Year 4 40000 • What is the payback period? At the end of 3 years, Darcy recovered $77,000. The remaining $10,000 is recovered in the 4th year. In the 4th year, every month earns an average of $40,000/12 = $3,333.33 … Hence, $10,000 is earned in $10,000 / 3,333.33 = 3 months. Answer: 3 Years 3 Months 8/18

9. Advantages of payback period assessment • Simplest and quickest • Helps to understand cash flow problems • Helps to understand technology depreciation • Can look at different investment ideas side by side • Helps understand time frames easier • Is relatively short term 9/18

10. Disadvantages of payback period assessment • Can encourage businesses to only think short term. • Also unrealistic for things like drug companies and real estate that need to think long term about investment. • Very hard to accurately predict long term returns • Time can become more important than overall profits. 10/18

11. Accounting Rate of Return • It is the average profit on investment project as percentage of the amount invested. • or • average profit ÷ average investment Note: Most businesses will compare the rate of return with other things they can use the money for like base interest rates. By subtracting the base interest rate from the ARR we can see what the real return is by taking the risk. ( ) x 100% total profit during projects number of years ÷ initial amount invested 11/18

12. Advantages & Disadvantages of ARR • Advantages of ARR is easy comparisons between different investment ideas. A business can then know the financial risk involved. • Disadvantages are that time of inflows and outflows of money can be very hard to determine. Also the lifespan of equipment can be very hard to determine. The longer we try to guess something the harder it can be to determine. 12/18

13. Work out the following issue: • Dr. A owns a company that teaches men how to dance. She is thinking about redoing the floor in her studio which should last for 4 years. The cost of the project will be 9 thousand pounds. She expects the following increase in profits over those four years. • Year 1 £ 2800 • Year 2 £ 3500 • Year 3 £ 3600 • Year 4 £ 5000 • The current interest rate is 3.5% • What is the ARR for the project? • What is the cash difference between the project and simply making bank interest? • Is the project a good idea? • Why does Dr. A’s calculated increase in profit go up every year? Total Profits = £ 14,900 ARR = (£ 14,900 ÷ 4) ÷ (9,000) x 100% = 41.3889% £ 1,260 Bank Interest = £ 9,000 x 0.035 x 4 = Cash Difference = £ 14,900 - £ 1,260= £ 13,640 Nett Profit from Project = £ 14,900 - £ 9,000= £ 5,900 Answer: 41.3889% Answer: £ 13,640 Yes! Recovered investment amount plus made profit. £ 5,900 nett profits versus £ 1,260 interest. Because the total number of customers increases each year. Higher fees are charged each year as the value of money decreases. 13/18

14. Work out the following issue: • Jack has a business that sells Huijia jackets on eBay. Jack thinks if he buys a new computer system he can work faster at buying and selling things for at least two years his increase in sales he believes will be: • First 6 months € 200 • Second 6 months € 100 • Third 6 months € 75 • Fourth 6 months € 25 • The new system costs € 2200 • Current interest rate is 7.5% • What is the ARR for buying the computer system? • Is the project a good idea? • What is the cash difference between the project’s total profits and simply making bank interest? • Why does Jack’s calculated increase in profit go down every six months? Total Profits = € 400 ARR = (€400 ÷ 2) ÷ (2,200) x 100% = 9.09% Bank Interest = € 2,200 x 0.075 x 2 = € 330 Cash Difference = € 400 - € 330= + € 70 Answer: 9.09% No! Because the initial investment is not recovered. Answer: + € 70 Because of technological depreciation. 14/18

15. Qualitative Investment Appraisal looks at everything in an investment idea – not just money 15/18

16. PORSCHE • Predictions - educated guesses about what will happen in the future with income and interest rates. • Objectives - Profit seeking firms will think about money while companies with other objectives may worry about CSR (corporate social responsibility) more. • Risk profile - Some businesses will want high risk high reward while others want safer investments. • State of the economy - if consumer and producer confidence are high businesses are more likely to take chances. • Corporate image - How will the public view something a business does. • Human relations - Some investments might make some jobs obsolete (redundant) which can affect a businesses staff negatively. • Exogenous shocks - unknown risks (natural disasters) 16/18

17. Quantitative Investment Appraisalcan be very effective in looking at decisions objectively. 17/18

18. Quantitative Investment Appraisal • It is very important to make sure that data is as good as it can get. Bad data or data that ignores some factors will be useless when you work your results. GIGO Principle (i.e. Garbage In Garbage Out) • Cash received in the future is not worth as much as cash received now. Inflation! • Also all businesses need to think about the whole picture when making an investment decision. Corporate objectives! • For example, it could be very profitable to sell cocaine but the social and political costs are huge. Social influence on both people and businesses!!! 18/18