Investment Appraisal
Methods
L3 Business
Studies
Investment
Buying the equipment needed to make or sell a
product/service.
IS
Buying
productive assets
IS NOT
Buying shares,
saving in the bank
or buying gold
Investment Appraisal
Deciding on the best investment choice from a possible
range.
involves
CHOI
CE
What
truck?
Investment Appraisal
Learning Objectives
3 methods:
Payback
Period
Accounting
Rate of
Return
Net
Present
Value
Investment is?
Discuss with your partner and make your choice.
Write it in your notes.
A
B
C
D
Putting
money in an
ASB account
Buying GOLD
bars and
storing them
Buying
productive
assets
Investing in
XERO shares
Investment is?
A
B
C
D
Putting
money in an
ASB account
Buying GOLD
bars and
storing them
Buying
productive
assets
Investing in
XERO shares
DECISIONS,
DECISIONS!
Glass company wants to grow and needs a
new delivery vehicle. It has decided on 3
possible options
HOW DOES IT MAKE A FINAL DECISION?
OPTION 1
OPTION 2
OPTION 3
Investment Appraisal
3 methods:
Payback
Period
Accounting
Rate of
Return
Net
Present
Value
Payback period
How long will it take to pay back the
initial investment from NET CASH
FLOWS
OPTION 1:
$45000 initial investment
OPTION 2
$36000 initial investment
OPTION 3
$60000 initial investment
Payback period
NET CASH FLOWS are …
Income received from asset minus costs of running asset
YOU WILL be given the NET CASH FLOW for
each investment option in the exam.
Payback period
$14000
$14000 $14000
$14000
$14000
0
OPTION 1:
1
2
3
4
Years (NET Cash Flow)
$45000
If the annual flows are all the same
… Initial Investment
Annual Net Cash
Flows
= PAYBACK
PERIOD
Give it a go yourself
5
Payback period
$14000
$14000 $14000
$14000
$14000
0
OPTION 1:
$45000
1
2
3
4
Years (NET Cash Flow)
5
Payback period
$10000
$9000
$9000
$12000
$12000
0
OPTION 2:
1
2
3
4
Years (NET Cash Flow)
$36000
If the annual flows are different …
Year
Net Cash
Flow
Total
1
$,000
2
$,000
$,000
3
$,000
$,000
4
$,000
$,000
Add each
year until you
have covered
your
investment
Give it a go yourself
5
Payback period
$10000
$9000
$9000
$12000
$12000
0
OPTION 2:
$36000
1
2
3
4
Years (NET Cash Flow)
5
Payback period
$18000 $22000 $26000
$26000
$30000
0
OPTION 3:
1
2
3
4
5
Years (NET Cash Flow)
$60000
PAYBACK a little harder to find?
YOUR TURN
A
B
C
D
3yrs 2 mths
2yrs 6 mths
3yrs 8mths
2yrs 10mths
Payback period
$18000 $22000 $26000
$26000
$30000
0
OPTION 3:
1
2
3
4
5
Years (NET Cash Flow)
$60000
PAYBACK a little harder to find?
YOUR TURN
A
B
C
D
3yrs 2 mths
2yrs 6 mths
3yrs 8mths
2yrs 10mths
Payback period
$18000 $22000 $26000
$26000
$30000
0
OPTION 3:
1
3
4
5
Years (NET Cash Flow)
$60000
Year
2
Net Cash
Flow
Total
1
$18,000
2
$22,000
$40,000
3
$26,000
$66,000
Need $60,00
Add each year
until you have
covered your
investment
Sometime in Yr2. Need extra 20,000 out of 26000
in Yr 3. 20,000/26,000= 0.769.
0.769 x 12mths = 9.23 or 10 months approx.
PAYBACK = 2 years and 10 months
Payback period
WHICH
PROJECT?
OPTION 1:
3yrs 3mths
OPTION 2
3yrs 8mths
OPTION 3
2yrs 10mths
Payback period
What are
the
Criteria?
OPTION 1:
3yrs 3mths
OPTION 2
3yrs 8m
OPTION 3
2yrs 10m
Accept if:
1. Fastest PAYBACK – OPTION 3
OR
2. Meets criteria eg. PAYBACK < 3 yrs – OPTION
3
Payback Period is?
A
B
C
D
A method for
paying off
debts
An approach
to help
decide on the
best
investment
The best form
of investment
appraisal
How long it
takes you to
pay for
equipment
Payback Period is?
A
B
C
D
A method for
paying off
debts
An approach
to help
decide on the
best
investment
The best form
of investment
appraisal
How long it
takes you to
pay for
equipment
Payback period
WEAKNESSES
This method ignores:
1. The total return on the investment project
(i.e. the earnings after payback).
2. The timing of the return (slow cash flows to
start could result in rejecting profitable
projects)
.
Investment Appraisal
3 methods:
Payback
Period
Accounting
Rate of
Return
Net
Present
Value
Average Rate of
Return
aka Accounting Rate of Return
Total Return considered. Expressed as a
%
OPTION 1:
$45000 initial investment
OPTION 2
$36000 initial investment
OPTION 3
$60000 initial investment
Average Rate of
Return
$14000
$14000Rate
$14000
$14000
aka
Accounting
of Return
$14000
0
OPTION 1:
1
2
$45000
3
4
5
Years (NET Cash Flow)
Total net cash flows = Total inflows minus initial
investment
Expected life of asset = Useful life of asset
Total Net Cash Flows from
Asset
Expected Life of
Asset
Average Annual Net Cash
Flows
Initial Investment
= Average Annual
NCF
= Accounting
Rate
of
Return
Average Rate of
Return
aka
Accounting Rate of Return
$14000 $14000 $14000 $14000
$14000
0
OPTION 1:
$45000
1
2
3
4
Years (NET Cash Flow)
Total NCF = 70000 – investment 45000
35000/5 = 7000 7000/45000 = 15.5%
5
Average Rate of
Return
aka
Accounting
of Return
$10000
$9000 Rate
$9000
$12000
$12000
0
OPTION 2:
$36000
1
2
3
4
5
Years (NET Cash Flow)
Total Cash inflows = 52000 Life = 5 yrs
52000 – 36000 = 16000/5 = 3200
3200/36000 = 8.9%
Average Rate of
Return
aka
Accounting
of Return
$18000
$22000 Rate
$26000
$26000
$30000
0
OPTION 3:
1
2
3
4
5
Years (NET Cash Flow)
$60000
YOUR TURN
A
B
C
D
12.6%
20.0%
20.7%
18.3%
Average Rate of
Return
aka
Accounting
of Return
$18000
$22000 Rate
$26000
$26000
$30000
0
OPTION 3:
1
2
3
4
5
Years (NET Cash Flow)
$60000
YOUR TURN
A
B
C
D
12.6%
20.0%
20.7%
18.3%
Average Rate of
Return
aka
Accounting
of Return
$18000
$22000 Rate
$26000
$26000
$30000
0
OPTION 3:
$60000
1
2
3
4
5
Years (NET Cash Flow)
HOW?
Total Cash Flows = 122000
Life = 5yrs
122000-60000= 62000/5 = 12400
12400/60000 = 20.7%
Average Rate of
Return
aka Accounting Rate of Return
WHICH
PROJECT?
OPTION 1:
15.5%
OPTION 2:
8.9%
OPTION 3:
20.7%
Average Rate of
Return
aka Accounting Rate of Return
What are
the
Criteria?
OPTION 1:
15.5%
OPTION 2:
8.9%
OPTION 3:
20.7%
Accept if:
1. Best ARR– OPTION 3
OR
2. Meets criteria eg. ARR > 16% – OPTION 3
Average Rate of
Return
aka Accounting Rate of Return
A
B
C
D
An
unsatisfactory
interest rate
An approach
to help
decide on the
best
investment
The best form
of investment
appraisal
aka
Economic
rate of return
Average Rate of
Return
aka Accounting Rate of Return
A
B
C
D
An
unsatisfactory
interest rate
An approach
to help
decide on the
best
investment
The best form
of investment
appraisal
aka
Economic
rate of return
Average Rate of
Return
aka Accounting Rate of Return
WEAKNESSES
Attaches no importance to the timing of the inflows of
cash. A.R.R treats all money as of equal value,
irrespective of when it is received.
Hence, a project may be favoured even though it
only produces a return over a long period of time.
.
Average Rate of
Return
aka Accounting Rate of Return
More sophisticated methods take the timing
and size of the cash inflows into account.
A sum of money in one year's time is worth less
than that same sum of money now (i.e. inflation
will erode the real value of that sum of money
over the year).
This is where the notion of present value is
used.
.
EXAM
QUESTION
EXAM
QUESTION
EXAM
QUESTION
EXAM
QUESTION
The new machinery will cost $730m
Expected net cash flows per year;
Year 1 194
Year 2 199
Year 3 207
Year 4 212
Year 5 217
EXAM
The new machinery will QUESTION
cost $730m
Expected net cash flows per year;
Year 1 194
Year 2 199
Year 3 207
Year 4 212
Year 5 217
Net Present Value
An approach to investment
appraisal that takes into account
the time value of money
Net Present Value
Sophisticated
Discounts Cash
Flows
Net Present Value
The value of future cash flows are
discounted back to present day
values.
A $dollar today is worth more than a
$dollar received in the future.
Net Present Value
If I gave you $1 today you could
invest it in the bank at current
interest rates.
The same $1 in a years time has not
been able to earn that interest so
has less value to me in todays
terms.
Net Present Value
Present value of net cash
inflows minus initial
investment
Information you need to
calculate:
Initial investment
Annual cash flows
A % discounting rate (k)
Net Present Value
Present value of net cash
inflows minus initial
investment
Cash Flow
1
(1 + k)
+
Cash Flow
+
2
2
(1 + k)
Cash Flow
3
3
(1 + k)
Cash Flow t
+
(1 + k)t
= NET PRESENT VALUE
Cash
- Flow 0
Net Present Value
Cash Flow
1
(1 + k)
+
Cash Flow
+
2
2
(1 + k)
Cash Flow
3
3
(1 + k)
Cash Flow t
+
(1 + k)t
Cash
- Flow 0
Net Present Value
Cash Flow
1
(1 + k)
+
Cash Flow
+
2
2
(1 + k)
$14000
Cash Flow
3
3
(1 + k)
$14000 $14000
Cash Flow t
+
(1 + k)t
$14000
Cash
- Flow 0
$14000
0
OPTION 1:
$45000
1
2
3
4
Years (NET Cash Flow)
We will use a discount rate of 8%
(.08).
5
Net Present Value
Cash Flow
1
(1 + k)
14000
(1 + 0.08)
+
+
Cash Flow
+
2
2
(1 + k)
14000
(1 + 0.08)2
+
Cash Flow
3
3
(1 + k)
14000
(1 + 0.08)3
+
Cash Flow t
+
(1 + k)t
14000
(1 + 0.08)
4
+
14000
(1 + 0.08)
12962.96 + 12002.74 + 11113.65 + 10290.42 + 9528.16 - 45000
=
$10897.93
5
Cash
- Flow 0
-
$45000
Net Present Value
$10000
$9000
$9000
$12000
$12000
0
OPTION 2:
$36000
1
2
3
4
Years (NET Cash Flow)
5
Net Present Value
$18000 $22000 $26000
$26000
$30000
0
OPTION 3:
1
2
3
4
5
Years (NET Cash Flow)
$60000
YOUR TURN – closest to
A
B
C
D
$12600
$20000
$41000
$36000
Net Present Value
$18000 $22000 $26000
$26000
$30000
0
OPTION 3:
1
2
3
4
5
Years (NET Cash Flow)
$60000
YOUR TURN – closest to
A
B
C
D
$12600
$20000
$41000
$36000
Net Present Value
$18000 $22000 $26000
$26000
$30000
0
OPTION 3:
$60000
1
2
3
4
Years (NET Cash Flow)
5
Net Present Value
WHICH
PROJECT?
OPTION 1:
$10898
OPTION 2:
$8058
OPTION 3:
$35696
Net Present Value
DECISION
CRITERIA?
OPTION 1: $10898
OPTION 2: $8058
OPTION 3: $35696
REJECT if
NPV is less
than zero
(reject none)
Net Present Value
DECISION
CRITERIA?
OPTION 1: $10898
OPTION 2: $8058
OPTION 3: $35696
ACCEPT if NPV
is positive
(accept all)
Choose largest
NPV
(Accept Option
3)
Investment Appraisal
Learning Objectives
3 methods:
Payback
Period
Accounting
Rate of
Return
Net
Present
Value
Investment Appraisal
Learning Objectives
3 methods:
Payback
Period
Accounting
Rate of
Return
Net
Present
Value
SIMPLES
T
SIMPLE
SOPHISTICAT
ED
Investment Appraisal
Learning Objectives
Payback
Period
SIMPLES
T
Your
3 methods:
Exam
Accounting
s
Rate of
Return
SIMPLE
Net
Present
Value
SOPHISTICAT
ED