3.2 Investment Appraisal Chapter 19 Investment 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 minus 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 consideration. 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 station. Projects in Charlotte? n Can you name projects that were successful or did not meet projected goals? Payback Method n Length of time required for net cash inflows to pay back the original capital investment. 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 sales ¡ 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 reasons? 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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