3.2 Investment Appraisal by pptfiles


									3.2 Investment Appraisal

      Topic 3

n   To purchase capital goods
    ¡   Equipment
    ¡   Vehicles
    ¡   New buildings
    ¡   Improving existing fixed assets
Investment Appraisal

n   Evaluating the profitability or desirability of
    an investment project

    ¡   Quantitative Investment Appraisal
        Using techniques to study the financial issues of
        investment (think Qty-$$$)
    ¡   Qualitative Appraisal
        Studying non-financial issues that may impact
        an investment decision
                  (think Quality and Impact)
Qualitative Investment Appraisal
n   Studying non-financial issues that may impact an
    investment decision
    ¡   Impact on the environment
    ¡   Bad publicity could harm company image and reduce
    ¡   Planning permission may not be granted or be hindered
        by pressure groups
    ¡   Aims and objectives of the business may be in opposition
        with project (a commitment to personalized customer
        service might hinder a project to computerize services)
    ¡   Risk….No amount of positive data can alter some
        management decisions they feel are unwise.
Quantitative Investment Appraisal

n   Requires the following information:
    ¡   Initial cost of investment (including installation)
    ¡   Estimated life expectancy (how many years can
        returns be expected from the investment)

    ¡   Residual value (at the end of its useful life, can the asset
        be sold for additional $$)

    ¡   Forecasted net returns or net cash flows
        from the project (money generated from the investment
        minus the annual running cost)
    Quantitative Investment Appraisal
             Three Methods

n    Payback Period
     Length of time required for net cash flows to pay
     back the original capital cost of the investment

n    Average Rate of Return
     Annual profitability of an investment as a
     percentage of the initial investment

n    Net Present Value
     Today’s value of the estimated future cash flows
     resulting from an investment
Forecasting Cash Flows
n   Cash Inflow       Annual Revenues
n   Cash Outflow      Annual Operating Costs
n   = Net Cash Flow

n   Problems occur when forecasting the future
    because no one can predict what external
    forces will effect cash flows.

n   This can make cash flow projections
    inaccurate. Manager must take this into
Payback Method

n   Length of time required for net cash
    inflows to pay back the original capital
n   Managers compare the payback
    period to alternative projects to put
    them in priority order.
Payback Method-
Considerations to Evaluate
n   A business could borrow the investment
    money….longer payback time means more
    interest payments.
n   Opportunity cost of money – what other
    projects could be funded.
n   The longer the payback period the more
    likely external factors could be a problem
    and are likely unpredictable.
n   Managers can be “risk averse” – faster
    payback is less risky by reducing uncertainty
n   Long payback can reduce the value of
    money by inflation.
Average Rate of Return (ARR)

n   Measures the annual profitability of an
    investment as a percentage of the
    initial investment.

           Annual Profit (Net Cash Flow)
ARR% =                                   X 100
               Initial Capital Cost
Why is ARR Important?

n   You can compare ARR on multiple projects.
n   Criterion Rate – a company may only accept
    projects that meet or exceed a certain ARR
    Rate…say 15% or more.
n   Annual interest rate on loans needs to be
    considered….if the ARR is 5% and the
    interest rate on money to fund the project is
    12%, it is not worth making the investment
     Net Present Value (NPR)
     n   Measures the “time value of money”…cash
         received in the future is not as valuable as cash
         received today.
         ¡   Money received today can be spent today without waiting

         ¡   Money received today can be invested and worth more
             than the same money received in the future
             $1000 today +$100 interest = $1100 vs $1000 in the

         ¡   Money received today is certain, future money is not

         ¡   Inflation makes money received in the future worth less
             than money received today
     Net Present Value (NPR)

     n   Discounting Future Cash Flows
           The NPR of future money depends
           on 2 things:

         ¡   The higher the interest rate, the less
             value future cash has in today’s money

         ¡   The longer into the future cash is
             received, the less value it has today

     Net Present Value (NPR)

     How do you calculate NPR:
       $3000 is expected in 3 year’s time.
       10% current interest rate.      Year 6%               8%    10%
       (Interest rate is also the discount rate)
                                                   1   .94   .93   .91
                                                   2   .89   .86   .83
                                                   3   .84   .79   .75
                                                   4   .79   .74   .68

     Apply the discount factor of .75
     $3000*.75=$2250 is the NPR value today
     Net Present Value (NPR)
     n   NPR does not give a % rate of return so it usually is
         not considered by itself.
     n   It does consider both timing of cash flows and their
     n   The discount rate can be varied to allow for different
     n   It can be complex and difficult to explain.
     n   Results are determined by the accuracy of the
         discount rate selected.
     n   NPR can only be compared with projects with the
         same initial capital cost since it is not percentage


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