INVESTMENT APPRAISAL
INVESTMENT
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investment: purchase of an asset with a potential to yield future financial benefits
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with most investments, resources are risked in a venture that may or may not yield future
advantages
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investment appraisal: the quantitative techniques used to calculate financial costs and benefits
of an investment decision or methods to assess the risks in investment decision making
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three main methods: PBP, ARR, NPV
companies need to assess whether the investment is worth it by counting the time period in which
they will get their money back
PAYBACK PERIOD (PBP)
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amount of time needed for an investment project to earn enough profit to repay the initial cost of
an investment
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PBP = initial investment cost ($) ÷ contribution per month ($)
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ex. a firm is considering buying a photocopy machine for $10,000
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anticipated financial gain is $6,000 per year after maintenance costs are paid
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PBP = $10,000 ÷ ($6,000/12 months)
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PBP = 20 months — so in 20 months, the investment has already paid by itself
how long are we going to get our money back
AVERAGE RATE OF RETURN (ARR)
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calculates the average profit on an investment project as a percentage of the amount invested
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ARR = [(total profit during project’s lifespan $ ÷ number of years of project) ÷ initial amount
invested $] x 100%
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the percentage it’s paying for based on its initial amount
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if last example is $10,000 will be paid in 20 months, ARR is like the percentage it’s going
to be paid per month
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the larger the % = the better it is — how much is it contributing per month
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allows managers to compare the return on other projects
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it is a benchmark and can be compared with the interest rate to assess the rewards for the
risk involved in an investment
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for large mncs, an ARR of 7% while interest on savings is 3% would yield a real rate of return of
4%
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advantage: enables easy comparisons (in %) if the estimated returns of different investment
projects
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ex. if two projects are predicted to yield the same ARR, the cheaper project might be
more desirable as it carries less financial risk
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weakness: ignores the timing of cash inflows
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prone to forecasting errors when considering seasonal factors
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if the time period is longer, it is even harder to predict the cash inflow/outcome
NET PRESENT VALUE
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look at current value of an item, assumes that you bought the item in the past
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calculating the remaining value of the item now
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you can also calculate the value if you’re buying the item now and assess its value later in the
future
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discounting — the reverse of calculating compound interest
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discount factor is used to convert the future net cash flow to its present value today
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given that receiving money today is worth more than it is in the future, the discount factor
can represent inflation and/or interest rates
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looking at the value of the item after its value gets reduced year after year
NPV = sum of present values - cost of investment
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sum of present values: sum of all discounted cash flows
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principal: original amount invested
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NPV is positive if it is greater than the principal
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if the discounted (future) cash flows are enough to justify the initial investment
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if NPV is negative, don’t do it
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but it doesn’t have to be negative to say that the investment is bad bc it depends
on the value that is acceptable for the person
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NPV will be positive if the discounted (future) cash flows are enough to justify the initial
investment
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limitation: but if it is positive, it should not be over-relied on bc interest rates may
increase in the next years
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calculations are complex
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doesn’t take into account the possible increase of interest rates
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results are only comparable if the initial investment cost is the same between
competing projects
EX. 3.8.4
b) calculate the ARR for Derogatis Computing Inc.
ARR = [(total profit during project’s lifespan $ ÷ number of years of project) ÷ initial amount invested $]
x 100%
= [(200,000 ÷ 4) ÷ 100,000] x 100%
= (50,000 ÷ 100,000) x 100%
= 50%
this is rly good because they planned the money to go back aft 4 years but it’s alr paid back aft 2
EX. 3.8.5
a) cost for Project Boston = $140,000
b) PBP = initial investment cost ($) ÷ contribution per month ($)
Project Atlanta = 24 months/2 years
Project Boston = 24 months + 4 months = 2 years 4 months
c) (i) ARR = [(total profit during project’s lifespan $ ÷ number of years of project) ÷ initial amount
invested $] x 100%
Project Atlanta
[(160,000 ÷ 3) ÷ 140,000] x 100 = 38.1%
Project Boston
[(180,000 ÷ 3) ÷ 140,000] x 100 = 42.9%
c) (ii) compound interest
Project Atlanta
(80,000 x 4.75) + 80,000 OR 80,000 x 1.0475
80,000 x 1.0475 = 83,800 + 60,000 = 143,800
143,800 x 1.0475 = 150,630.50 + 20,000 = 170,630.50
170,630.50 x 1.0475 = 178,735.449 = 178,735.50
Project Boston
60,000 x 1.0475 = 62,850 + 60,000 = 122,850
122,850 x 1.0475 = 128,685.375 + 60,000 = 188,685.375
188,685.375 x 1.0475 = 197,647.93
d) pbp, arr, compound interest and discounting. 6 marks
pbp for boston is this, pbp for atlanta is this, therefore for pbp, this is better
and so on for the other tools
conclusion: state which one is better
if there is 7 or 8 marks, then there is going to be points for the conclusion