Investment Appraisal

UNIT 3.8
 Investment refers to the capital
expenditure of a business (purchase of
Investment appraisal: process of
fixed assets or a business venture)
quantifying financial risks of an investment
with the intention of a financial return
decision. It helps to determine if a capital
on the investment.
investment is worthwhile, by examining
the costs of investing and the expected
return on investment.
 Investment Appraisal – Why?
Businesses do not always get their investment decisions right - which is why
investment appraisal is an important decision making tool.
▪ Along with Steve Wozniak and Steve Jobs, Ronald Wayne co-founded Apple. Ronald
Wayne sold his shares for only $800 after just 12 days with the company. He had a
10% in the company, which would be worth around $130 billion.
▪ In 1999, a web portal company called Excite passed on the offer to buy Google for
$1 million. According to Forbes, Google has a market valuation of around $1
trillion.
▪ Blockbuster refused a partnership proposal made by Netflix back in 2000.
Blockbuster went bankrupt in 2011. As of May 2020, Netflix had more than 193
million paid subscribers.
PAYBACK PERIOD (PBP)
Payback period
▪ The time it takes for the initial amount of money invested to be repaid
using the gains from the original investment.
▪ Estimates how long it will take a business to break-even on (or “pay
back”) its investment.
▪ The PBP is measured in terms of years and/or months.
▪ The original amount of the investment is known as the capital outlay or
principal.
▪ A quantitative management tool to assess whether a project is
financially worthwhile and to justify the capital expenditure needed.
 Calculating PBP

A shorter payback period is preferred to a longer one, as it

minimizes the risks of investment and indicates profit at an earlier
date. The larger the contribution (or net cash flow) per month, the
shorter the payback period.
Supreme Computing Inc. is considering spending $71,500 on new 3D printers.
The annual contribution from this investment is forecast to be $33,000.
Calculate the payback period for Supreme Computing Inc. 

⮚ Cost of investment = $71500

⮚ Contribution = $33000 (annual)

⮚ Contribution per month = 33000/12 = $ 2750

PBP = 71500/2750 = 26 months = 2 years and 2 months

 If cash flow or return is different for each
month…
Year Net Cash
Thornton Inc. is Flow
$
deciding whether to
spend $78,000 on a 1 20000
new machine that is 2 24000

expected to generate 3 30000

the net cash flow 4 24000

over 5 years. 5 20000

 Step 1: Calculate the cumulative net cash
flow.
Year Net Cash Calculation
Thornton Inc. is Flow
$
deciding whether to
spend $78,000 on a 1 20000 20000
new machine that is 2 24000 20000+24000

expected to generate 3 30000 44000+30000

the net cash flow 4 24000 74000+24000

over 5 years. 5 20000 98000+20000

 Step 1: Calculate the cumulative net cash
flow.
Year Net Cash Calculation Cumulative Cash
Thornton Inc. is Flow Flow
$ $
deciding whether to
spend $78,000 on a 1 20000 20000 20000
new machine that is 2 24000 20000+24000 44000

expected to generate 3 30000 44000+30000 74000

the net cash flow 4 24000 74000+24000 98000

over 5 years. 5 20000 98000+20000 118000

 Step 2: Identify the year in which the cumulative NCF is
equal to or greater than the initial cost of the investment.
Year Net Cash Flow Cumulative Cash Flow
$ $

1 20000 20000
2 24000 44000
3 30000 74000
4 24000 98000
5 20000 118000
 Step 3: Calculate the monthly NCF in that year.

Year Net Cash Flow Cumulative Cash Flow

$ $
In Year 4, the
monthly NCF is
1 20000 20000 $24,000 ÷ 12 =
2 24000 44000 $2,000 per month
3 30000 74000
4 24000 98000
5 20000 118000
Step 4: Calculate the shortfall to reach payback in the
previous year.
Year Net Cash Flow Cumulative Cash Flow Shortfall in year 3=
$ $ $78,000 – $74,000
= $ 4000
1 20000 20000
2 24000 44000 This means that in year
3 30000 74000 3 the firm will recover
4 24000 98000 $74000, and only $
4000 will be left for
5 20000 118000
recovery.
Step 5: Divide the difference found in Step 4 by the answer
in Step 3.
Year Net Cash Flow Cumulative Cash Flow Shortfall / monthly
$ $ NCF in yr. 4
$4,000 ÷ $2,000 = 2
1 20000 20000 months.
2 24000 44000
3 30000 74000
4 24000 98000 Therefore, PBP is 3
5 20000 118000 years and 2 months
Practice question
Rowlands Printing Co. is considering an investment of $380,000 on new
printing machines. The project is expected to generate the following net
cash flows in the five years that the machines are expected to last, before
they need replacing and upgrading: ($120000, $140000, $180000, $150000,
$110000).
Rowlands Printing Co. has suffered from liquidity problems recently,
although it remains profitable.
Year Net Cash
Flow $
1 120000
2 140000
3 180000
4 150000
5 110000
Yea Net Cash Cumulative
r Flow $ cash flow
1 120000 120000 120000
2 140000 140000+12000 260000 Cost of capital = $ 380000
0
3 180000 260000+18000 440000
0
4 150000 440000+15000 590000
0
5 110000 590000+11000 700000
0
Yea Net Cash Cumulative
r Flow $ cash flow
Cost of capital = $ 380000
1 120000 120000 Figure equal to or higher than cost of investment is
2 140000 260000 $440000 (year 3)
3 180000 440000 Monthly Cash Flow for year 3 = 180000/12
4 150000 590000 = $ 15000
5 110000 700000
Yea Net Cash Cumulative Cost of capital = $ 380000
r Flow $ cash flow
Monthly Cash Flow for year 3 = $ 15000
1 120000 120000
2 140000 260000 Shortfall from year 2 = cost of capital less year 2 cash
3 180000 440000 flow: 380000 – 260000 = $120000
4 150000 590000
5 110000 700000 Firm has to recover $120000 during year 3
 Cost of capital = $ 380000
Monthly Cash Flow for year 3 = $ 15000
Yea Net Cash Cumulative
r Flow $ cash flow Shortfall from year 2 = cost of capital less year 2 cash
1 120000 120000 flow: 380000 – 260000 = $120000
2 140000 260000 Firm has to recover $120000 during year 3
3 180000 440000
4 150000 590000 i.e. shortfall/monthly NCF in year 3
5 110000 700000 120000/15000 = 8 months.
PBP is 2 years and 8 months
 Advantages of payback period

▪ Easiest and fastest method to calculate investment appraisal.

▪ Results are easy to understand.
▪ Useful for businesses that suffer from cash flow (liquidity) problems, small
sole traders, or those trying to survive a recession.
▪ Suitable for businesses in fast-changing industries, where products and
trends can become outdated quite quickly.
▪ It aids decision making, as investments with a short PBP show reduced risks.
 Disadvantages of payback period

▪ Does not take into account the timing of cash flows and contributions
to profit.
▪ Not usually suitable for long-term projects with a long PBP, as it may
inflate the risk of a major investment.
▪ No consideration to the net benefits after the PBP.
▪ Does not reveal the profitability of an investment, but focuses on the
time needed to recover the costs of the project.
 EduPro is planning to reinvest a portion from their retained earnings in buying new
equipment. The cost of the equipment is $34000. The cash flow from the investment
are estimated as $(100000), $30000, $40000, $60000, $35000 for the first five years.
Calculate how long the firm will take to recover the cost of its investment.

Yr. NCF Cumulative Cost of investment = $34000

Cash flow
Year of recovery is year 5
1 (100000) (100000)
Monthly return in year 5 = 35000/12 =
2 30000 (70000) $2917
3 40000 (30000) Shortfall = 34000 – 30000 = $4000
Recovery of shortfall = 4000 / 2917
4 60000 30000
months
5 35000 65000 = 1.37 months
PBP is 4 years and 2 months
Average Rate of Return
CALCULATES THE FORECAST AVERAGE ANNUAL PROFIT OF AN
INVESTMENT PROJECT EXPRESSED AS A PERCENTAGE OF THE
INITIAL AMOUNT OF MONEY INVESTED.
Average Rate of Return (ARR)
ARR must exceed the prevailing interest rate in banks, otherwise the business is
better off placing their money in the bank and earning the interest without the
risks associated with investments.
A high ARR means the proposed investment project is more financially attractive.
⮚ Unlike the PBP, the ARR focuses on the profits from an investment, rather than
length of time it takes for a project to pay for itself.
⮚ Used to compare the relative attractiveness of different investment projects.
⮚ ARR may overestimate the true value of the financial returns on an investment.
⮚ ARR focuses on estimated profits rather than on cash flow.
Example 1 - ARR
The purchase of a new computer system that costs
$350000 is forecast to generate the following net cash
flows over the next five years (when It needs to be
replaced): $100000, $130000, $180000, $150000, $100000.
Calculate ARR.
Example 1 - working
Step 1: Calculate total cash inflow over the five years
$100000 + $130000 + $180000 + $150000 + $100000 = $660000
Step 2: Calculate projected profit (Total cash inflow – investment)
$660000 - $350000 = $310000
Step 3: Calculate Average annual profit
$310 000 / 5 years= $62 000 per year
Step 4: Calculate ARR (Ave. annual profit/cost of investment)
$62 000 / $350 000 = 17.7% OR 18%
 Recap of November 3 - ARR

The 4 stages in calculating ARR:

Step 1. Add all positive cash flows

Step 2. Subtract cost of investment
Step 3. Divide by lifespan
Step 4. Calculate the % return to find the ARR
 Example 2 - Calculating ARR

Chislehurst Garden Centre (CGC) is investigating the feasibility of replacing

its fleet of delivery vehicles. The new vehicles would cost $560,000. The
investment would increase CGC’s annual sales revenue by $150,000 but
raise costs by $50,000 a year. The estimated useful life of the new vehicles
is 8 years with no scrap (second-hand) value. The management at CGC
prefer all investment projects to have an average rate of return (ARR) of
no less than 5%.
 Example 2 - Calculating ARR

Annual net profit (or contribution) = Estimated annual

revenue less annual costs
= $150,000 – $50,000 = $100,000
 Example 2 - Calculating ARR

Annual net profit (or contribution) = $100,000

Total projected profit = (Annual contribution x
estimated life) less initial investment
($100,000 × 8 years) – $560,000 = $240,000
 Example 2 - Calculating ARR

Annual net profit (or contribution) = $100,000

Total projected profit = $240,000
Ave. annual profit = Total projected profit / estimated
life
$240,000 / 8 years = $30,000
 Example 2 - Calculating ARR

Annual net profit (or contribution) = $100,000

Total projected profit = $240,000
Ave. annual profit = $30,000
ARR = $30,000 ÷ $560,000 = 5.36%
Case study 3.8.2
Year Net Cash Flow

Project Atlanta
Project Boston ($)
($)
0 (140000) (150000)
1 80000 60000
2 60000 60000
3 20000 60000
Case study 3.8.2
PBP – Cumulative Cash Flow
Project Project Boston
Atlanta ($) ($)

0 (140000) - (150000) -

1 80000 80000 60000 60000

2 60000 140000 60000 120000

3 20000 160000 60000 180000

Case study 3.8.2
PBP – Recovery year
Project Project Boston
Atlanta ($) ($)

0 (140000) - (150000) -

1 80000 80000 60000 60000

2 60000 140000 60000 120000

3 20000 160000 60000 180000

 Case study 3.8.2
PBP – Calculation of PBP
Project Project
Atlanta Boston
($) ($)

(14000 (150000
0 - - PBP Project Atlanta:
0) )
1 80000 80000 60000 60000 Payback period is year 2
14000
2 60000 60000 120000
0
16000
3 20000 60000 180000
0
 Case study 3.8.2
PBP – Calculation of PBP
PBP Project Boston:
Project Project Payback year is year 3
Atlanta Boston
($) ($) Per month cash flow in year 3:
(14000 (150000 60000/12 = $5000
0 - -
0) ) Shortfall in year 2:
1 80000 80000 60000 60000 150000 – 120000 = $30000
14000 Shortfall months:
2 60000 60000 120000
0
16000 30000/5000 = 6 months
3 20000 60000 180000
0 PBP = 2 years and 6 months
 Case study 3.8.2
Calculation of ARR
Yr Net Cash Flow ARR Project Atlanta:
Project Project Boston Projected profit = Total cash flow – cost of
Atlanta ($) ($)
investment
0 (140000) (150000)
160000 – 140000 = $20000
1 80000 60000
Average Annual Profit = Projected profit /lifespan
2 60000 60000
20000/3 =$6667
3 20000 60000 ARR = Average Annual Profit / initial investment
Total 160000 180000 (6667/140000) x 100 = 4.76%
Net Present Value (NPV)

HL ONLY TOPIC
What is Net Present Value?
An Investment costs $ 1000.
In 3 years, it will bring in $100 as revenue.
What is Net Present Value?
An Investment costs $ 1000.

In 3 years, it will bring in $100 as revenue.

The big question: How much should I invest

TODAY to earn that $100 in 3 years?
What is Net Present Value?
The big question: How much do I need to
invest TODAY to earn that $100 in 3 years?
Let’s say interest is 5%,
To earn $ 100, in 3 years @ 5% interest, I must
invest $86.38 today.
This is what we’ll learn today!
Let’s define NPV
Basic principle: Money received today can be invested or saved in
a bank to earn compound interest, whereas money received in the
future will lose some of its value.
Net present value (NPV) is a method of investment appraisal that
calculates the real value rather than the absolute value of an
investment by discounting* or adjusting the actual value of
money received in the future.
*Discounting is the reverse compound interest. It establishes the
present value of cash that is yet to be received by the business.
DISCOUNT FACTORS
 Calculating NPV

New mechanization for a firm is estimated to cost $300000 and should

last for five years. It will cost an estimated $50000 per annum to
maintain but will increase the value of the firm's output by an
estimated $150000. Interest rates are currently 5%. Calculate the NPV
on the proposed investment.
 Calculating NPV

Cost = $300000
Lifespan = 5yrs Step 1: Calculate Annual Net Cash Flow
Cash outflow = $50000 NCF = cash inflow minus cash outflow
Cash inflow = $150000
Interest@5% NCF = $150000 - $50000 = $100000 p.a.
 Calculating NPV

Step 2: Find relevant discount factors.

Yr. Net Cash Flow Discount
Cost = $300000 Factor
Lifespan = 5yrs 1 100000 0.9524
Cash outflow = $50000 2 100000 0.9070
3 100000 0.8638
Cash inflow = $150000
4 100000 0.8227
Interest@5% 5 100000 0.7835
Total 500000
 Calculating NPV

Step 3: Find present values.

Yr. Net Cash Flow Discount Factor Present
Cost = $300000 Value
1 100000 0.9524 95240
Lifespan = 5yrs
2 100000 0.9070 90700
Cash outflow = $50000
3 100000 0.8638 86380
Cash inflow = $150000 4 100000 0.8227 82270
Interest@5% 5 100000 0.7835 78350
Total 500000 432940
 Calculating NPV
Step 4: Find Net Present Values
Yr. Net Cash Flow Discount Factor Present
Cost = $300000 Value
1 100000 0.9524 95240
Lifespan = 5yrs
2 100000 0.9070 90700
Cash outflow = $50000
3 100000 0.8638 86380
Cash inflow = $150000 4 100000 0.8227 82270
Interest@5% 5 100000 0.7835 78350
Total 500000 432940
NPV = Sum of present
values minus Cost of
Investment
 Calculating NPV
Step 5: Assess the feasibility
Cost = $300000 NPV = Sum of present Which means that if
values minus Cost of
Lifespan = 5yrs Investment
the firm invests the
Cash outflow = $50000 $300000 instead of
buying the
Cash inflow = $150000 machines, it would
Interest@5% NPV = $432940 - earn $132940 per
$300000 = $132940 year.
Analysis of NPV

The greater the NPV, the more feasible the investment

proposal/decision becomes.

The longer the investment project under consideration, the less

accurate it becomes to forecast future net cash flows – and the
more likely interest rates are to change.
Case Study 3.8.3
Case Study 3.8.4
 Advantages of using Net Present Value

⮚ Accounts for the future movements of cash flows from an

investment project or decision.
⮚ More realistic than ARR especially for projects that are medium
to long term.
⮚ Firm can make more informed comparisons between projects of
varying durations and with different discount rates.
 Disadvantages of using Net Present
Value

⮚ Difficult to accurately predict future net cash flows, especially for

medium to long term projects.
⮚ More difficult and time consuming to calculate and may still be
inaccurate since it is based on long-term predictions.
⮚ Choosing a discount rate can be subjective.