Investment Appraisal by pptfiles


									3.2 Investment Appraisal

      Chapter 19

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)
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
              Two 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
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
Why is there uncertainty here?

n   A project to construct a factory to
    make large and expensive luxury cars
n   An investment in a new computerized
    banking system offering customers
    new services using state-of-the-art
    equipment that has not yet been
    thoroughly tested.
Why is there uncertainty here?

n   Cash-flow forecasts for a new sports
    center that are based on a small
    market research sample.
n   The building of a new toll motorway
    between two cities.
n   The construction of an oil-fired power
Projects in Charlotte?

n   Can you name projects that were
    successful or did not meet projected
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
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.
Qualitative Investment Appraisal

n   Can you think of projects that were
    “shelved” because of qualitative

n   We make simple qualitative and
    quantitative decisions every day.
n   How can you apply quantitative or
    qualitative appraisal to your life?

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