2 Aims and Objectives Aim: To understand the payback investment appraisal techniqueObjectives:Define investment and investment appraisalDescribe the uses of investment appraisalCalculate payback period.Analyse payback period.
3 Starter LO1: Define investment and investment appraisal. In pairs define:Investment appraisalIn pairs decide on why investment appraisal may be important.
4 Investment Appraisal Definition Investment: Decision to spend an amount of money on something that will benefit the business in long run. E.g. fixed asset, stakes in another businessDefinition Investment Appraisal:The process of analysing the financial benefits of a possible future investment.
5 Investment Appraisal Importance of Investment Appraisal: Investment is important, as it may help achieve objectives, particularly a growth strategy.Appraisal is important to judge the benefits of an investment decision and to judge the investment decisions of managers.
6 Making Investment Decisions Two major considerations for managers when making investment decisions:Total profits earned by the investment over the foreseeable future.How quickly will the investment recover it’s cost?
7 Investment Appraisal Techniques PaybackAverage Rate of ReturnNet Present Value
8 Investment Appraisal Techniques Financial figures must be considered alongside qualitative factors.QuantitativeResultsNon-financial factors must be consideredQualitative Factors
9 Payback Method Definition: Calculates how long it will take to recoup (get back) the initial investment.Note:Before calculating any investment appraisals, tables must be drawn up to show net cash flow for each option.
10 Payback MethodStep 1: Add up net cash flows of Machine A until there is enough to cover the initial investment. Initial Investment = £750,000 £142, , ,500 = £587,800 = Not enough to cover initial investment £142, , , ,500 = £840,000 = Enough to cover initial investment
11 Payback Method£142, , , ,500 = £840,000 = £840,000 recouped after 4 years, but we want to know when £750,000 is paid back….Therefore:By year 4 enough money has come in from the new machine to cover the initial investment of £750,000.However this is not accurate in terms of calculating months. £840,000 - £750,000 = £90,000 overPayback is therefore 3 years and ‘x’ months.
12 Payback MethodStep 2: Add up net cash flows of Machine A until end of year 3. (we know the payback period falls between year 3 and year 4, but not in which month) £142, , ,500 = £587,800 = Year 3 Total Net Cash Flow
13 Payback MethodStep 2: Initial Investment minus Year 3 total cash flow. £750,000 – £587,800 = £162,200 = Remaining cash needed to pay back the investment in year 3. Remaining Cash x12 Net Cash Flow In Year Calculated in Step 1
14 Payback MethodStep 3: Calculate the month in which investment can be paid back. £162,200 x12 £252,500 = 7.7 months, rounded up to 8 months
15 Payback MethodStep 4: The payback period is therefore three years and eight months.
16 Payback MethodTask: Calculate the payback period for Machine B. Analyse which option as managers of Walkers you should chose and why.
17 Payback Period Analysed Benefits of Payback MethodShorter the payback period the less risky the investment, the quicker it can generate profits from its’ investment.Good to use if business has cash flow problems, or if investment is in assets which outdate quickly.Important to use if investment funded by external finance.
18 Payback Period Analysed Drawback of Payback PeriodFails to look at cash flows after the payback period, ignoring overall profitability of the investment.Assumes that in the year of payback the inflow of cash is steady across the year, which may not be true.Especially for seasonal businesses!