An Introduction to Investment Appraisal

Investment Appraisal Revenue expenditure provides

benefits for the current year. Capital expenditure provide

benefits for longer than a year. Both types of expenditure need

careful evaluation. Investment appraisal seeks to look

at cost/benefit analysis.

Basic requirements of investment appraisal

Defining objectives. Identifying investment possibilities.

Wide ranging. Could be constrained for legal or

political reasons. However there will always be two

options: Do nothing. Investment option.

Basic requirements of investment appraisal Evaluating the costs and benefits of

investments. Assess size of costs and benefits. Assess timing of expenditure and when

potential returns can be expected. However it is important to recognise that costs

and benefits arise at different times and are therefore not directly comparable.

How do you forecast the future? We need to consider whether it is better to

have £1000 now or £1500 in one year’s time.

Basic requirements of investment appraisal

Private sector Benefits can be expressed in future

cash flows i.e. in monetary terms. How can qualitative factors be taken

into consideration? (These are more important than you may think!)

Basic requirements of investment appraisal

Public sector The economic and social advantages

(benefits) are compared with the disadvantages (costs) and then quantified in monetary terms.

Sometimes it is difficult to quantify these in monetary terms.

Methods of Project Appraisal

Payback (This week) Accounting rate of return (This

week) Net Present Value (Next week) Internal Rate of Return (Next

week)

Pay Back Calculates the time it takes to recover the initial

investment Method of calculating Pay Back

Year Cash Flow Cumulative cash flow0 (100,000) (100,000)1 20,000 (80,000)2 40,000 (40,000)3 50,000 10,000

Therefore the Payback period is between Years 2 and 3

Pay Back The Payback period is the number of years needed

to recover the original investment from the cash flows resulting from an investment project.

Payback tries to take account of risk, if by risk we mean that the forecasting of cash flows become more uncertain the more distant they become.

However this method ignores the time value of money, the timing of cash flows within the payback period and any cash flows after the payback period. It does not say whether a project is a ‘good’ one.

Pay Back Periods

Project A£ £

Initial Cost (50 000)Net Cash InflowsYear 1 10 000Year 2 20 000Year 3 20 000Year 4 10 000What is the Payback Period?

Accounting Rate of Return Accounting Rate of Return (ARR) Accounting Rate of Return (ARR) is the ratio of average

annual profit to average capital invested. It is simple to apply, looks at the whole of an investment project and can be used to compare projects. A project is acceptable if the ARR exceeds a target value such as current ROCE.

ARR = average annual accounting profit x 100average investment (AI)

WhereAI = initial investment + scrap value

2

Example Consider buying a machine for £100,000 which will be

worth £20,000 in 5 years time. (This latter value is known as the scrap value.)

Cash Flows for the next 5 years will be as follows:

Year 1 £20,000Year 2 £40,000Year 3 £60,000Year 4 £60,000Year 5 £20,000

Profit = Cash Flow - Depreciation

ARRAssuming straight line depreciation

Average depreciation = (£100k-£20k)/5 = £16k p.a.

Average Annual Profit = (4+24+44+44+4)/5=£24k

Average Investment = Cost of Machine+Disposal Value2

AI = 100 + 20 = £60k 2

ARR

ARR = (24/60) * 100 = 40%

To decide whether or not this is acceptable, we need to compare this percentage with the minimum required by the business.

Accounting Rate of Return (ARR) ARR and the Return on Capital Employed (ROCE) ratio take the same

approach to performance measurement. ROCE is a popular method for measuring performance after the asset has performed and ARR measures the potential before it has performed.

Remember that PROFIT DOES NOT EQUAL CASH FLOW ARR ignores the time value of money, fails to take account of the size and

timing of cash flows and uses profits rather than cash flows. For investment appraisal purposes, it is cash flows rather than accounting

profits that are important.

Example - ARRProject A

£Initial Capital Expenditure (90 000)Cash Flows Year 1 55 000

Year 2 50 000Year 3 45 000Year 4 40 000

Scrap Value at end of project 10 000

Calculate the ARR

Example - ARRProject A

£Initial Capital Expenditure (50 000)Profit/Loss Year 1 25 000

Year 2 20 000Year 3 15 000Year 4 10 000

Scrap Value at end of project 10 000

Calculate the ARR.

Problems with ARR

A B CYear 0 Cost of Machine (320) (320)

(320)Year 1 Net Profit after Dep 20 10 160Year 2 Net Profit after Dep 40 10 10Year 3 Net Profit after Dep 60 10 10Year 4 Net Profit after Dep 60 10 10Year 5 Net Profit after Dep 20 160 10

Which project would you choose ?