- Investment appraisal
- Evaluation of investments using quantitative techniques (looking for potential net gains)
- Capital investment is based on 3 factors
- Firm’s objectives
- Opportunities
- Constraints
- Qualitative issues that can be faced in making an investment
- Objectives of the firm
- External costs and benefits
- Current or expected state of the economy
- Past experiences
- Corporate image
- Whether the investment will conflict with a company’s values
- Exogenous shocks
- Unexpected economical change (e.g. fall in stock prices, rise in prices of housing, etc.)
- Cash flows
- Estimated profits over the lifetime of the investment
- Cumulative cash flow
- Cash flow based on total cash is subtracted by total cash out for a specific duration of time
- Cumulative cash flow = Total cash out – Net cash flow up to that period
- Methods of investment appraisal
- Payback period (PBP)
- Time it takes for an investment to repay the initial outlay
- Calculation is based on cash flows
- Short term, works with the nearest month
- Calculate month of payback = (Income required / Contribution per month)
- Contribution per month = (Cash flow for next year / 12)
- Important notes
- Projects with long payback will be disregarded but payback will rarely be used by itself to make an investment decision
- How much of a deterrent is high risk?
- Advantage
- Simple and quick
- Firms can identify how long they can recoup and whether or not it will break-even on a purchased asset
- Compare different investment projects
- Assess projects that yields quick returns
- Short term, so calculations are less prone to forecasting errors
- Disadvantages
- Encourages short-term approach to investment
- Contribution per month is likely to be constant
- Focuses on time as the key criterion rather than profit
- Lacks qualitative assessment
- Average rate of return (ARR)
- Calculates the average profit of an investment as a % of the investment
- Expressed as % to allow comparisons between investment projects with different initial outlays
- Computation
- Calculate profit over lifetime of investment
- (Total cumulative cash flow – initial outlay) / No. of years of investment’s life span
- ARR = (Average annual profit / Initial outlay) * 100
- Advantages
- Enables easy comparisons of the returns of different projects
- Disadvantages
- Ignores timing of cash inflows (e.g. seasonal factors)
- Project’s lifespan is needed, which might just be a random guess
- Errors are likelier the longer the forecasting period
- Net present value (HL only)
- Calculates sum of all future expected net cash flows
- Used to find out the value of future profits today (as money received in the future is worth less than if received today due to inflation)
- Process
- Calculate annual net cash flows of the project
- Select appropriate rate of interest or required rate of return
- Obtain the discount factor
- Multiply net cash flow by discount factors
- Add present net values for each of the net cash flows
- Compare total net present value with initial outlay
Kim De Leon3.8. Investment Appraisal