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Investment Appraisal Methods L3 Business Studies

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Investment Buying the equipment needed to make or sell a product/service. IS Buying productive assets IS NOT Buying shares, saving in the bank or buying gold

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Investment Appraisal Deciding on the best investment choice from a possible range. involves CHOI CE What truck?

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Investment Appraisal Learning Objectives 3 methods: Payback Period Accounting Rate of Return Net Present Value

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Investment is? Discuss with your partner and make your choice. Write it in your notes. A Putting money in an ASB account B Buying GOLD bars and storing them C Buying productive assets D Investing in XERO shares

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Investment is? A Putting money in an ASB account B Buying GOLD bars and storing them D Investing in XERO shares C Buying productive assets

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Glass company wants to grow and needs a new delivery vehicle. It has decided on 3 possible options HOW DOES IT MAKE A FINAL DECISION? Glass company wants to grow and needs a new delivery vehicle. It has decided on 3 possible options HOW DOES IT MAKE A FINAL DECISION? OPTION 1 OPTION 2 OPTION 3 DECISIONS, DECISIONS!

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Investment Appraisal 3 methods: Payback Period Accounting Rate of Return Net Present Value

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Payback period How long will it take to pay back the initial investment from NET CASH FLOWS OPTION 1: $45000 initial investment OPTION 2 $36000 initial investment OPTION 3 $60000 initial investment

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Payback period NET CASH FLOWS are … Income received from asset minus costs of running asset YOU WILL be given the NET CASH FLOW for each investment option in the exam. NET CASH FLOWS are … Income received from asset minus costs of running asset YOU WILL be given the NET CASH FLOW for each investment option in the exam.

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Payback period 0 1 2345 OPTION 1: $14000 Years (NET Cash Flow) $45000 $14000 Initial Investment Annual Net Cash Flows = PAYBACK PERIOD If the annual flows are all the same … Give it a go yourself

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Payback period 0 1 2345 OPTION 1: $14000 Years (NET Cash Flow) $45000 $14000

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Payback period 0 1 2345 OPTION 2: $10000 Years (NET Cash Flow) $36000 $9000 $12000 If the annual flows are different … Give it a go yourself YearNet Cash Flow Total 1$,000 2 3 4 Add each year until you have covered your investment

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Payback period 0 1 2345 OPTION 2: $10000 Years (NET Cash Flow) $36000 $9000 $12000

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Payback period 0 1 2345 OPTION 3: $18000 Years (NET Cash Flow) $60000 $22000$26000 $30000 PAYBACK a little harder to find? YOUR TURN PAYBACK a little harder to find? YOUR TURN A 3yrs 2 mths B 2yrs 6 mths C 3yrs 8mths D 2yrs 10mths

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Payback period 0 1 2345 OPTION 3: $18000 Years (NET Cash Flow) $60000 $22000$26000 $30000 PAYBACK a little harder to find? YOUR TURN PAYBACK a little harder to find? YOUR TURN A 3yrs 2 mths B 2yrs 6 mths C 3yrs 8mths D 2yrs 10mths

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Payback period 0 1 2345 OPTION 3: $18000 Years (NET Cash Flow) $60000 $22000$26000 $30000 YearNet Cash Flow Total 1$18,000 2$22,000$40,000 3$26,000$66,000 Need $60,00 Add each year until you have covered your investment Need $60,00 Add each year until you have covered your investment Sometime in Yr2. Need extra 20,000 out of 26000 in Yr 3. 20,000/26,000= 0.769. 0.769 x 12mths = 9.23 or 10 months approx. PAYBACK = 2 years and 10 months

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Payback period WHICH PROJECT? OPTION 1: 3yrs 3mths OPTION 2 3yrs 8mths OPTION 3 2yrs 10mths

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Accept if: 1. Fastest PAYBACK – OPTION 3 OR 2. Meets criteria eg. PAYBACK < 3 yrs – OPTION 3 Payback period What are the Criteria? OPTION 1: 3yrs 3mths OPTION 2 3yrs 8mths OPTION 3 2yrs 10mths

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Payback Period is? A A method for paying off debts B An approach to help decide on the best investment C The best form of investment appraisal D How long it takes you to pay for equipment

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Payback Period is? A A method for paying off debts C The best form of investment appraisal D How long it takes you to pay for equipment B An approach to help decide on the best investment

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Payback period WEAKNESSES This method ignores: 1.The total return on the investment project (i.e. the earnings after payback). 2.The timing of the return (slow cash flows to start could result in rejecting profitable projects).

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Investment Appraisal 3 methods: Payback Period Accounting Rate of Return Net Present Value

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Average Rate of Return aka Accounting Rate of Return Total Return considered. Expressed as a % OPTION 1: $45000 initial investment OPTION 2 $36000 initial investment OPTION 3 $60000 initial investment

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0 1 2345 OPTION 1: $14000 Years (NET Cash Flow) $45000 $14000 Average Rate of Return aka Accounting Rate of Return Total Net Cash Flows from Asset Expected Life of Asset = Average Annual NCF Initial Investment Average Annual Net Cash Flows = Accounting Rate of Return Total net cash flows = Total inflows minus initial investment Expected life of asset = Useful life of asset

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0 1 2345 OPTION 1: $14000 Years (NET Cash Flow) $45000 $14000 Total NCF = 70000 – investment 45000 35000/5 = 70007000/45000 = 15.5% Total NCF = 70000 – investment 45000 35000/5 = 70007000/45000 = 15.5% Average Rate of Return aka Accounting Rate of Return

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Average Rate of Return aka Accounting Rate of Return 0 1 2345 OPTION 2: $10000 Years (NET Cash Flow) $36000 $9000 $12000 Total Cash inflows = 52000Life = 5 yrs 52000 – 36000 = 16000/5 = 3200 3200/36000 = 8.9% Total Cash inflows = 52000Life = 5 yrs 52000 – 36000 = 16000/5 = 3200 3200/36000 = 8.9%

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Average Rate of Return aka Accounting Rate of Return 0 1 2345 OPTION 3: $18000 Years (NET Cash Flow) $60000 $22000$26000 $30000 YOUR TURN YOUR TURN A 12.6% B 20.0% C 20.7% D 18.3%

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Average Rate of Return aka Accounting Rate of Return 0 1 2345 OPTION 3: $18000 Years (NET Cash Flow) $60000 $22000$26000 $30000 YOUR TURN YOUR TURN A 12.6% B 20.0% D 18.3% C 20.7%

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Average Rate of Return aka Accounting Rate of Return 0 1 2345 OPTION 3: $18000 Years (NET Cash Flow) $60000 $22000$26000 $30000 HOW? Total Cash Flows = 122000Life = 5yrs 122000-60000= 62000/5 = 12400 12400/60000 = 20.7% HOW? Total Cash Flows = 122000Life = 5yrs 122000-60000= 62000/5 = 12400 12400/60000 = 20.7%

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WHICH PROJECT? OPTION 1: 15.5% OPTION 2: 8.9% OPTION 3: 20.7% Average Rate of Return aka Accounting Rate of Return

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Accept if: 1. Best ARR– OPTION 3 OR 2. Meets criteria eg. ARR > 16% – OPTION 3 What are the Criteria? Average Rate of Return aka Accounting Rate of Return OPTION 1: 15.5% OPTION 2: 8.9% OPTION 3: 20.7%

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A An unsatisfactory interest rate B An approach to help decide on the best investment C The best form of investment appraisal D aka Economic rate of return Average Rate of Return aka Accounting Rate of Return

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Average Rate of Return aka Accounting Rate of Return A An unsatisfactory interest rate C The best form of investment appraisal D aka Economic rate of return B An approach to help decide on the best investment

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WEAKNESSES Attaches no importance to the timing of the inflows of cash. A.R.R treats all money as of equal value, irrespective of when it is received. Hence, a project may be favoured even though it only produces a return over a long period of time.. Average Rate of Return aka Accounting Rate of Return

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More sophisticated methods take the timing and size of the cash inflows into account. A sum of money in one year's time is worth less than that same sum of money now (i.e. inflation will erode the real value of that sum of money over the year). This is where the notion of present value is used.. Average Rate of Return aka Accounting Rate of Return

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EXAM QUESTION

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The new machinery will cost $730m Expected net cash flows per year; Year 1 194Year 2 199Year 3 207Year 4 212Year 5 217

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EXAM QUESTION The new machinery will cost $730m Expected net cash flows per year; Year 1 194Year 2 199Year 3 207Year 4 212Year 5 217

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Net Present Value An approach to investment appraisal that takes into account the time value of money

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Net Present Value Sophisticated Discounts Cash Flows Sophisticated Discounts Cash Flows

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The value of future cash flows are discounted back to present day values. A $dollar today is worth more than a $dollar received in the future. The value of future cash flows are discounted back to present day values. A $dollar today is worth more than a $dollar received in the future. Net Present Value

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If I gave you $1 today you could invest it in the bank at current interest rates. The same $1 in a years time has not been able to earn that interest so has less value to me in todays terms. If I gave you $1 today you could invest it in the bank at current interest rates. The same $1 in a years time has not been able to earn that interest so has less value to me in todays terms. Net Present Value

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Information you need to calculate: Initial investment Annual cash flows A % discounting rate (k) Information you need to calculate: Initial investment Annual cash flows A % discounting rate (k) Net Present Value Present value of net cash inflows minus initial investment

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Net Present Value Present value of net cash inflows minus initial investment Cash Flow 1 (1 + k) = Cash Flow 2 (1 + k) + Cash Flow 3 (1 + k) Cash Flow t (1 + k) + + 2 3t - Cash Flow 0 NET PRESENT VALUE

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Net Present Value Cash Flow 1 (1 + k) Cash Flow 2 (1 + k) + Cash Flow 3 (1 + k) Cash Flow t (1 + k) + + 2 3t - Cash Flow 0

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Net Present Value Cash Flow 1 (1 + k) Cash Flow 2 (1 + k) + Cash Flow 3 (1 + k) Cash Flow t (1 + k) + + 2 3t - Cash Flow 0 0 1 2345 OPTION 1: $14000 Years (NET Cash Flow) $45000 $14000 We will use a discount rate of 8% (.08). You will be given this in the exam

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Net Present Value Cash Flow 1 (1 + k) Cash Flow 2 (1 + k) + Cash Flow 3 (1 + k) Cash Flow t (1 + k) + + 2 3t - Cash Flow 0 14000 (1 + 0.08) = ++ 23 - $45000 (1 + 0.08) 14000 (1 + 0.08) + 4 14000 + 5 (1 + 0.08) 12962.96 + 12002.74 + 11113.65 + 10290.42 + 9528.16 - 45000 $10897.93

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Net Present Value 0 1 2345 OPTION 2: $10000 Years (NET Cash Flow) $36000 $9000 $12000

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Net Present Value 0 1 2345 OPTION 3: $18000 Years (NET Cash Flow) $60000 $22000$26000 $30000 YOUR TURN – closest to YOUR TURN – closest to A $12600 B $20000 C $41000 D $36000

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Net Present Value 0 1 2345 OPTION 3: $18000 Years (NET Cash Flow) $60000 $22000$26000 $30000 YOUR TURN – closest to YOUR TURN – closest to A $12600 B $20000 C $41000 D $36000

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Net Present Value 0 1 2345 OPTION 3: $18000 Years (NET Cash Flow) $60000 $22000$26000 $30000

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Net Present Value WHICH PROJECT? OPTION 1: $10898 OPTION 2: $8058 OPTION 3: $35696

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Net Present Value DECISION CRITERIA? OPTION 1: $10898 OPTION 2: $8058 OPTION 3: $35696 REJECT if NPV is less than zero (reject none) REJECT if NPV is less than zero (reject none)

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Net Present Value DECISION CRITERIA? OPTION 1: $10898 OPTION 2: $8058 OPTION 3: $35696 ACCEPT if NPV is positive (accept all) Choose largest NPV (Accept Option 3) ACCEPT if NPV is positive (accept all) Choose largest NPV (Accept Option 3)

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Investment Appraisal Learning Objectives 3 methods: Payback Period Accounting Rate of Return Net Present Value

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Investment Appraisal Learning Objectives 3 methods: Payback Period Accounting Rate of Return Net Present Value SIMPLES T SIMPLE SOPHISTICAT ED

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Investment Appraisal Learning Objectives 3 methods: Payback Period Accounting Rate of Return Net Present Value SIMPLES T SIMPLE SOPHISTICAT ED Your Exam s

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