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+ Investment Appraisal

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+ What is investment appraisal? Techniques to help managers decide on the best investment from a range of options Investment includes purchase of plant, vehicles, buildings or investing money Financial investment appraisal techniques are used alongside non financial factors Different methods can be used and all have their own advantages and disadvantages

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+ Information needed … Before you can undertake any investment appraisal you need to know: The amount of the investment (eg how much will it cost) How long the investment will last The income associated with the investment – this may be expressed as profit or cashflow

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+ For example Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4.

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+ Methods Traditional Payback Accounting rate of return (ARR) Non-traditional (Discounted cash flow) Net Present Value Internal Rate of Return

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+ Payback How long will it take to payback the initial investment? The easiest and quickest method of appraisal Can decide quickly whether the payback period is acceptable – company may have a cut-off period Short payback projects may improve a companys liquidity Short payback projects may be less risky BUT payback doesnt take into account the time value of money AND payback doesnt take into account cash flows after the payback period THEREFORE it is only used as a first level of investment appraisal

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+ Calculating Payback: Construct a Payback Table Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4. YearAnnual Cash Flows Cumulative

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+ Calculating Payback: Fill in the Payback Table Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4. YearAnnual Cash Flows Cumulative 0(15,000) 110,000(5,000) 26,0001,000 33,0004,000 41,0005,000

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+ Calculating Payback YearAnnual Cash Flows Cumulative 0(15,000) 110,000(5,000) 26,0001,000 33,0004,000 41,0005,000 Payback sometime during Year 2 Assuming all cash flows are equally spread throughout the year: 5,000/6000 x 365 = 304.16 Round UP Payback period = 1 year and 305 days

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+ Accounting Rate of Return Average profit against average investment, expressed as a % Enables managers to compare returns from one investment against expected returns from other investments Managers may have a specific ARR that they are aiming to achieve Simple to calculate Takes account of profits over the whole life of the project HOWEVER, does not take into account time value of money AND is based on accounting profit, not cash flow

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+ Calculating Accounting Rate of Return Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4. Average Profit / Average investment x 100 Revenue – Expenses = Profit

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+ Calculating Accounting Rate of Return Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4. Average Profit / Average investment x 100 Revenue – Expenses = Profit Always check the question – are the figures cash flow or profits? In this case theyre cash flows so you need to calculate the profits

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+ Calculating Accounting Rate of Return Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4. Average Profit / Average investment x 100 Revenue – Expenses = Profit (10,000+6,000+3,000+1,000) – 15,000 = 5,000 Average Profit = 5,000/4 years = £1,250 Average Investment = (Investment at start + book value of investment at end) / 2 15,000 / 2 = 7500

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+ Calculating Accounting Rate of Return Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4. Average Profit / Average investment x 100 Revenue – Expenses = Profit (10,000+6,000+3,000+1,000) – 15,000 = 5,000 Average Profit = 5,000/4 years = £1,250 Average Investment = (Investment at start + book value of investment at end) / 2 15,000 / 2 = 7500 Investment at start £15,000 This was depreciated over the 4 years so investment at end is £0

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+ Calculating Accounting Rate of Return Your organisation is considering investing in new machinery at a cost of £15,000. This is expected to generate additional cash inflows of £10,000 in year 1, £6,000 in year 2, £3,000 in year 3 and £1,000 in year 4. Average Profit / Average investment x 100 Revenue – Expenses = Profit (10,000+6,000+3,000+1,000) – 15,000 = 5,000 Average Profit = 5,000/4 years = £1,250 Average Investment = (Investment at start + book value of investment at end) / 2 15,000 / 2 = 7500 ARR = 1,250 / 7500 x 100 ARR = 17%

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1 Investment Appraisal Geoff Leese Sept 1999 revised Sept 2001, Jan 2003, Jan 2006, Jan 2007, Jan 2008, Dec 2008 (special thanks to Geoff Leese)

1 Investment Appraisal Geoff Leese Sept 1999 revised Sept 2001, Jan 2003, Jan 2006, Jan 2007, Jan 2008, Dec 2008 (special thanks to Geoff Leese)

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