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INVESTMENT APPRAISAL (SL) BUSINESS & MANAGEMENT A COURSE COMPANION (p158-159)

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INVESTMENT APPRAISAL Once a business is up and running and making a profit, its directors next thoughts turn to expansion. This often comes down to making choices about which project or opportunity to invest in; hence the term investment appraisal. A variety of quantitative techniques are used to help explain which investment might be the best choice, but remember there are also qualitative techniques that are equally valid in helping inform decision makers.

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Payback This measures the time it takes to recover enough cash to cover an initial investment or outlay. The formula is: Initial Investment Annual Cash Flow from the Investment We can calculate payback when the project generates the same annual return & when a project generates different annual returns.

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Payback – when the project generates the same annual return with whole years Example: A company buys a machine for $100,000 The machine generates the following annual returns The payback from this investment is obviously 4 years: Initial Investment (100,000) Annual Cash Flow from the Investment (25,000) = 4. YEARRevenue generated from using the machine Year 1$25,000 Year 2$25,000 Year 3$25,000 Year 4$25,000

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Payback with the project produces different returns each year Example: A new factory costs $240 million to build. The factory generates the following annual returns In this situation using the formula could lead to a misleading answer. Instead we simply need to calculate the number of whole years & fractional years. Answer: $80 (1 year) + $80 (1 year) + $70 (1 year) + (10 / 60 x 12 months = 2 months) Therefore the Payback period is 3 years & 2 months. YEARRevenue generated from using the factory 180 2 370 460

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Exercise – Payback. The XYZ Factory project will cost $450 million. The project is anticipated to produce the following annual revenue. Calculate the payback period. YEARRevenue generated from the project 1140 2160 3130 4120

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Average Rate of Return (ARR) Instead of just considering the revenue generated from a project, it is possible to consider the net return (profit) that a specific project generates. The formula is: Net Return (profit) per annum x 100 Capital Outlay (cost)

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Average Rate of Return - Example A machine is purchased for $195,000. Each year the machine allows the business to generate the revenues below. There are also maintenance/operational costs which must be deducted to get net revenues. Calculate the ARR (Average Rate of Return) for this machine/project. Year CostsRevenues Net Revenues Net Profit 0 day of purchase -195,0000 1 -10,00085,000 2 -12,000110,000 3 -13,000120,000 4 -14,000110,000 5 -12,000100,000 Totals

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Average Rate of Return (ARR) Solution to Example Year CostsRevenues Net Revenues- Net Profit 0 day of purchase -195,0000 1 -10,00085,000 +75,000 2 -12,000110,000 +98,000 3 -13,000120,000+107,000 4 -14,000110,000 +96,000 5 -12,000100,000 +88,000 Totals -256,000 525,000 269,000 Using the net revenue total figure, we can calculate the net return / profit per annum. $269,000 / 5 = 53,800. We divided by 5 for 5 years. Now we just use the formula. 53,800 / 195,000 x 100 = 27.58%

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Average Rate of Return – Exercise A fleet of buses is purchased for 1,000,000. Each year the buses allows the business to generate the revenues below. There are also maintenance costs which must be deducted to get net revenues. Calculate the ARR (Average Rate of Return) for this bus acquisition project. Year CostsRevenues Net Revenues Net Profit 0 day of purchase -1,000,0000 1 -10,000250,500 2 -12,000350,000 3 -13,000400,000 4 -14,000375,000 5 -12,000310,000 Totals

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Average Rate of Return – Exercise Year CostsRevenues Net Revenues Net Profit 0 day of purchase -1,000,0000 1 -10,000250,500 2 -12,000350,000 3 -13,000400,000 4 -14,000375,000 5 -12,000310,000 Totals

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