Investment Appraisal

Investment Appraisal

What is an investment appraisal? • Evaluating the profitability of an investment project • There are 3 methods of quantitative investment appraisal which are: • Payback period • Average Rate of Return • Net Present Value using discounted cash flows

Payback period • Length of time it takes for the net cash inflows to pay back the original capital cost of the investment

Example 1

Method: Payback Period • The annual cash flow in year # depends on how much time the debt can be repaid. For example in Team B, the cost of take over is $70m. We have to calculate in which year the business is able to repay its debt so that we can find the additional cash inflow needed. Team B has a cash inflow of $15m in year 1, $18m in year 2, $21m in year 3, $24m in year 4 and $30 in year 5. From these figures, we have to calculate in which year whether the total amount of cash inflow is either equal or greater than the initial cost of the investment. This will fit into the denominator of the equation. • To calculate ‘additional cash inflow needed’, we take the # from the denominator and minus it by 1 to find the total cash inflow from year 1 to that number. E.g. ‘Annual cash flow in year #’ is 4 so subtracting 1 from it will result to year 3. Add the values together of year 1, 2 and 3 to give you the total cash inflow in those years. Take the initial cost of investment and subtract it to get the ‘additional cash inflow needed’.

Method: Team B • Initial cost of investment: $70m • Cash inflow for year: • 1: $15m • 2: $18m • 3: $21m • 4: $24m • 5: $30m • Year 1 + 2 + 3 + 4 = 15+18+21+24 = $78m • Which means that year 4 is when the debt will be repaid. • 4th year – 1 year = 3rd year • Total cash inflow in year 3 = 15+18+21 = $54m • Initial cost of investment – Total cash inflow in year 3 = Additional cash inflow needed. • 78-70 = $8m Total payback period = 3 years and 4 months

Advantages & Disadvantages of using Payback Period

Average Rate of Return (ARR) • It measures the annual profitability of an investment as a percentage of the initial investment • We have to assume that the net cash flow = profit • Annual profit =

Example - ARR • Team A • Initial capital cost: $200m • Expected returns in year • 1: -30 • 2: -2 • 3: 76 • 4: 96 • 5: 150 • 29%

Advantages & Disadvantages of ARR

Net Present Value • Todays value of the estimated cash flows resulting from an investment • Uses discounted cash flows Method: 1. Multiply discount factors by the cash flows. Cash flows in year 0 are never discounted as they are today’s values already2. Add the discounted cash flows3. Subtract the capital cost to give the NPV

Example – Net Present Value • Team B • To get the future value, multiply the present value($m) by the discounted rate(inflation) • Then add all the future values = 79.308 = 79.31 (2dp) • Subtract the initial cost of capital by the total of future values to give you the Net Present Value (NPV) • NPV = $9.31m

Advantages & Disadvantages of Net Present Value

Investment Appraisal