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IB Business and Management
3.2 Investment Appraisal
Learning Outcomes
• Calculate Payback Period and ARR for an Investment
• Analyse the results of calculations• Calculate the NPV for an investment (HL)• Analyse the results of the calculations (HL)
Definition
Investment appraisal is the process of businesses evaluating whether an investment is attractive
Or, where alternatives exist, which option is likely to be the best.
Investments:• tie up the firm’s finance
for a long period, normally for a number of years;
• generate financial benefits (profits) over most or all of their useful life;
• often have a resale or scrap value at the end of their life.
• Because of the major capital outlays involved, managers try to calculate expected profitability/ cash flows for the proposed investment.
BEFORE WE START LOOKING AT TECHNIQUES……. CONSIDER THE FOLLOWING INVESTMENT DECISION
Which investment should be chosen?
Investment AInvestment A Investment BInvestment B Investment CInvestment C
Initial CostInitial Cost £70,000£70,000 £100,000£100,000 £200,000£200,000
Estimated Profit Estimated Profit GeneratedGenerated
Year 1Year 1 £10,000£10,000 £50,000£50,000 £20,000£20,000
Year 2Year 2 £10,000£10,000 £40,000£40,000 £30,000£30,000
Year 3Year 3 £20,000£20,000 £40,000£40,000 £30,000£30,000
Year 4Year 4 £20,000£20,000 £30,000£30,000 £60,000£60,000
Year 5Year 5 £30,000£30,000 £100,000£100,000
Year 6Year 6 £40,000£40,000 £100,000£100,000
Quantitative Techniques
• Payback
• Average Rate of Return (ARR)
• Net Present Value (NPV)
PAYBACK PERIOD
Payback
• This method of investment appraisal calculates how long it takes a project to repay its original investment.
• The shorter the payback period, the more faourable the investment
• It highlights investments which pay back the initial investment the quickest
Payback – Which Investment should be chosen?
Investment AInvestment A Investment BInvestment B Investment CInvestment C
Initial CostInitial Cost £70,000£70,000 £70,000£70,000 £70,000£70,000
Estimated Profit Estimated Profit GeneratedGenerated
Year 1Year 1 £10,000£10,000 £20,000£20,000 £30,000£30,000
Year 2Year 2 £10,000£10,000 £20,000£20,000 £30,000£30,000
Year 3Year 3 £20,000£20,000 £20,000£20,000 £20,000£20,000
Year 4Year 4 £20,000£20,000 £20,000£20,000 £10,000£10,000
Year 5Year 5 £30,000£30,000 £20,000£20,000 £10,000£10,000
Year 6Year 6 £40,000£40,000 £20,000£20,000 £10,000£10,000
TotalTotal £130,000£130,000 £120,000£120,000 £110,000£110,000
Results
• Investment C would be chosen because it has the shortest payback time, i.e. slightly less than three years.
• Investment A’s payback stretches into the fifth year and Investment B’s into the fourth.
Note that total income is not taken into account in this method. In fact Project C has the lowest total return over the 6 years.
Calculating the exact pay back period
Investment AInvestment A
Initial CostInitial Cost £70,000£70,000
Estimated Profit Estimated Profit GeneratedGenerated
Year 1Year 1 £10,000£10,000
Year 2Year 2 £10,000£10,000
Year 3Year 3 £20,000£20,000
Year 4Year 4 £20,000£20,000
Year 5Year 5 £30,000£30,000
Year 6Year 6 £40,000£40,000
TotalTotal £130,000£130,000
In order to make back the £70,000£70,000Investment we need:
-All of the profits from years 1-4-Plus £10,000 of the £30,000 £10,000 of the £30,000 generated in year 5generated in year 5
-The payback period is therefore 4 The payback period is therefore 4 years plus 10,000/30,000 years plus 10,000/30,000
In DaysIn Days10,000/30,000 X 365 = 10,000/30,000 X 365 =
In WeeksIn Weeks10,000/30,000 X 52 = 10,000/30,000 X 52 =
In MonthsIn Months10,000/30,000 X 12= 10,000/30,000 X 12=
Question
Project AProject A Project BProject B
Initial CostInitial Cost £8,000£8,000 £6,000£6,000
IncomeIncome
Year 1Year 1 £3,000£3,000 £5,000£5,000
Year 2Year 2 £5,000£5,000 £4,000£4,000
Year 3Year 3 £9,000£9,000 £6,000£6,000
TotalTotal £17,000£17,000 £15,000£15,000
Which project should the company choose fi payback period is being used?
Answer
• Both projects have the same return over 3 years.• Project A has a payback of 2 years• Project B has a payback of 1 year 3 months• Therefore Project has the shortest payback time
and should be chosen
AVERAGE RATE OF RETURN
ARR- Average Rate of Return
• The ARR method measures the net return each year as a percentage of the initial cost of the investment.
The formula for ARR is:
Average Annual Profit X 100 Initial Outlay
ExampleProject XProject X Project YProject Y Project ZProject Z
CostCost £50,000£50,000 £40,000£40,000 £90,000£90,000
Return:Return:
Year 1Year 1 £10,000£10,000 £10,000£10,000 £20,000£20,000
Year 2Year 2 £10,000£10,000 £10,000£10,000 £20,000£20,000
Year 3Year 3 £10,000£10,000 £20,000£20,000 £30,000£30,000
Year 4Year 4 £20,000£20,000 £20,000£20,000 £30,000£30,000
Year 5Year 5 £20,000£20,000 £30,000£30,000
Step 1- Calculate Total Net Profit
This is total profits over the life time of the investment with the initial investment deducted
£70,000 - £50,000 = £20,000 for Project X.
Step 2 – Calculate Annual Profit
The next step is to calculate the net profit per annum by dividing the total net profit by the number of years the project runs for
•£20,000 5 = £4,000 for Project X.
Step 3 – Calculate the ARR
Average Annual Profit X 100 Initial Outlay
For Project X £4,000 x 100 = 8%£50,000
Overall Results – Calculate the ARR for Project Y and Project Z
Project XProject X Project YProject Y Project ZProject Z
Initial CostInitial Cost £50,000£50,000
Total Net Total Net ProfitProfit
£20,000£20,000
Net Profit Net Profit per Annumper Annum
£4,000£4,000
ARRARR 8%8%
Overall Results…Which Project should be
chosen?Project XProject X Project YProject Y Project ZProject Z
Initial CostInitial Cost £50,000£50,000 £40,000£40,000 £90,000£90,000
Total Net Total Net ProfitProfit
£20,000£20,000 £20,000£20,000 £40,000£40,000
Net Profit Net Profit per Annumper Annum
£4,000£4,000 £5,000£5,000 £8,000£8,000
ARRARR 8%8% 12.5 %12.5 % 8.9%8.9%
Come back to this decision from the start of the lesson
Investment AInvestment A Investment BInvestment B Investment CInvestment C
Initial CostInitial Cost £70,000£70,000 £100,000£100,000 £200,000£200,000
Estimated Profit Estimated Profit GeneratedGenerated
Year 1Year 1 £10,000£10,000 £50,000£50,000 £20,000£20,000
Year 2Year 2 £10,000£10,000 £40,000£40,000 £30,000£30,000
Year 3Year 3 £20,000£20,000 £40,000£40,000 £30,000£30,000
Year 4Year 4 £20,000£20,000 £30,000£30,000 £60,000£60,000
Year 5Year 5 £30,000£30,000 £100,000£100,000
Year 6Year 6 £40,000£40,000 £100,000£100,000
Calculate the Payback and ARR for each of these Investments. Which one do you think should be chosen? Why?
Task – Practice Questions
• Answer the questions:
• Payback and ARR Quick Questions• Pilgrims Choice (Payback and ARR)
NET PRESENT VALUEThe Higher Level Stuff
Money now is more valuable than money later on……
Why?
Present Values
So $1,000 now is the same as $1,100 next year (at 10% interest)
We say the Present Value of $1,100 next year is $1,000
And on and on……
So…. Businesses might find it useful to know the Present Values of future profits they expect to make
Example
Investment A promises you $90,0 00 in 3 years, what is the Present Value?•To take a future payment backwards three years divide by 1.10 three times•So $90,000 in 3 years is:•$90,000 ÷ 1.10 ÷ 1.10 ÷ 1.10 •$90,000 ÷ (1.10 × 1.10 × 1.10) = 1.103
•$90,000 ÷ 1.331•$67,618 now
Question: What would the difference be if only a 5% interest rate was assumed?
Net Present Value
• NPV is a method of investment appraisal that take the present value of future profits/cashflows into account rather than the nominal value
• It therefore favours investments that bring in profits/cashflows more immediately
• It considers overall profitability of investments at present values
Making decisions using NPV
Normally the project with the highest NPV will be chosen.
• If the NPV is positive - cash benefits exceed cash costs - this means that the project will earn a return in excess of its cost of capital (the rate of interest/discounting used in the calculation).
• If the NPV is negative - this tells the managers that the cost of investing in the project exceeds the present value of future receipts, and that it is not worth investing in it.
Example Question
YearYear Project AProject A Project BProject B
00 -250-250 -250-250
11 +50+50 +200+200
22 +100+100 +100+100
33 +200+200 +50+50
Assuming that the interest rate is 10%, calculate the NPV of both projects and decide which one would be the better investment
Use the discount table
Example Answers(Assuming an interest rate of 10%)
Project A
Returns Discount Factor
Year 0 -£250
Year 1 +£50
Year 2 +£100
Year 3 +£200
1.00
0.91
0.83
0.75 £150
£83
£45.50
-£250
Present Value
Net Present Value = £28.50
Example Answers(Assuming an interest rate of 10%)
Project B
Returns Discount Factor
Year 0 -£250
Year 1 +200
Year 2 +£100
Year 3 +£50
1.00
0.91
0.83
0.75 £37.50
£83
£182
-£250
Present Value
Net Present Value = £52.50
Question (All values in £)
YearYear Investment AInvestment A Investment BInvestment B
00 -800-800 -500-500
11 300300 100100
22 300300 150150
33 300300 250250
44 300300 250250
55 300300 300300
Calculate the Net Present Value for these two investments assuming a discount factor of 8%
Answers
YearYear Investment Investment AA
Discount Discount FactorFactor
Present Present ValueValue
00 -800-800 1.001.00 -800-800
11 300300 0.890.89 267267
22 300300 0.800.80 240240
33 300300 0.710.71 213213
44 300300 0.640.64 192192
55 300300 0.570.57 171171
NPV=NPV= 283283
Answers
YearYear Investment Investment BB
Discount Discount FactorFactor
Present Present ValueValue
00 -500-500 1.001.00 -500-500
11 100100 0.890.89 8989
22 150150 0.800.80 120120
33 250250 0.710.71 177.50177.50
44 250250 0.640.64 160160
55 300300 0.570.57 171171
NPV=NPV= 217.50217.50
Interpretation
• Purely based on NPV Investment A should be chosen with a return of £283 against a return of £217.50 for investment B
• However if we look at the return as a % of the initial investment Project A = 35% whereas Project B = 44%.
• The company may wish to look at non-financial factors to help them make the decision
Task - Questions
• Answer the questions:
• NPV Quick Questions• Pilgrims Choice (NPV)
EVALUATING EACH METHOD….
Task
• Each group take one method of Investment Appraisal.
• Try to come up with your own list of advantages and disadvantages of each method.
• Payback• ARR• NPV
Payback PeriodAdvantages and Disadvantages
Advantages• it is easy to calculate
and understand• its use emphasises
liquidity, because the calculations are based exclusively on cash flows
• it helps managers to reduce risk by selecting the project which recovers its outlay most quickly
Limitations• cash earned after the
‘payback’ is not taken into account in the decision to invest
• it completely ignores the potential profits that can be earned since the criterion is the speed of repayment
• Short-termism• Doesn’t take into
consideration decreasing value of money
Average Rate of ReturnAdvantages and Limitations
Advantages• it is simple to calculate
and understand• it shows clearly the
profitability of an investment project
• it allows a better comparison of alternative projects, because it is related to the size of the initial investment outlay
• Can be directly compared to bank interest rates
Limitations• it disregards the fact
that money received at a later date does not possess the same real value as money received today
Net Present ValueAdvantages and Limitations
Advantages• Net Present Value
takes into account that interest rates affect the present value of future income.
• future cashflows are discounted by a ‘discount factor’ that the firm decides on and is affected by the rate of interest
Limitations• It is time consuming
and more difficult to calculate than payback and ARR
• Choosing the right discount factor can be difficult
QUALITATIVE FACTORSWhat else should be taken into account?
Introduction
• Investment Appraisal provides a scientific decision-making technique for managers
• However financial data do not always show the full picture, so a firm must not base its decisions solely on investment appraisal results.
• Other factors to be considered, and their relative importance will vary according to circumstances
Key Qualitative Factors
• The aims of the organisation• Liquidity position• Reliability of data• Production Requirements• Personnel• The economy• Image/public relations• Subjective factors
Timed IB Question – 18 minutes
• Answer the Altair Incorporated question
(SL students only have to do ARR and Payback. Q1 will only be worth 5 marks and only 13 minutes will be given)
Discount Table
Years Years AheadAhead
6%6% 8%8% 10%10% 12%12% 15%15%
00 1.001.00 1.001.00 1.001.00 1.001.00 1.001.00
11 0.940.94 0.930.93 0.910.91 0.890.89 0.870.87
22 0.890.89 0.860.86 0.830.83 0.800.80 0.760.76
33 0.840.84 0.790.79 0.750.75 0.710.71 0.660.66
44 0.790.79 0.740.74 0.680.68 0.640.64 0.570.57
55 0.750.75 0.680.68 0.620.62 0.570.57 0.500.50