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3.8. Investment Appraisal Summary

  • 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 experiencesCorporate 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
        • The calculation is based on cash flows
        • Short term, works with the nearest monthCalculate 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 decisionHow much of a deterrent is high risk?
          Advantage
          • Simple and quickFirms can identify how long they can recoup and whether or not it will break-even on a purchased assetCompare 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 the 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 the annual net cash flows of the project
      • Select the appropriate rate of interest or required rate of return
      • Obtain the discount factorMultiply net cash flow by discount factors
      • Add present net values for each of the net cash flows
      • Compare the total net present value with initial outlay

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