1. IB Business and Management
3.2 Investment Appraisal

2. Learning Outcomes Calculate Payback Period and ARR for an Investment
Analyse the results of calculations
Calculate the NPV for an investment (HL)
Analyse the results of the calculations (HL)

3. Definition
Investment appraisal is the process of businesses evaluating whether an investment is attractive Or, where alternatives exist, which option is likely to be the best.

4. Investments:
tie up the firm’s finance for a long period, normally for a number of years;
generate financial benefits (profits) over most or all of their useful life;
often have a resale or scrap value at the end of their life.
Because of the major capital outlays involved, managers try to calculate expected profitability/ cash flows for the proposed investment.

5. Before we start looking at techniques……
Before we start looking at techniques……. Consider the following investment decision

6. Which investment should be chosen?
Investment A
Investment B
Investment C
Initial Cost
£70,000
£100,000
£200,000
Estimated Profit Generated
Year 1
£10,000
£50,000
£20,000
Year 2
£40,000
£30,000
Year 3
Year 4
£60,000
Year 5
Year 6

7. Quantitative Techniques
Payback
Average Rate of Return (ARR)
Net Present Value (NPV)

8. Payback period

9. Payback
This method of investment appraisal calculates how long it takes a project to repay its original investment.
The shorter the payback period, the more faourable the investment
It highlights investments which pay back the initial investment the quickest

10. Payback – Which Investment should be chosen?
Investment A
Investment B
Investment C
Initial Cost
£70,000
Estimated Profit Generated
Year 1
£10,000
£20,000
£30,000
Year 2
Year 3
Year 4
Year 5
Year 6
£40,000
Total
£130,000
£120,000
£110,000

11. Results
Investment C would be chosen because it has the shortest payback time, i.e. slightly less than three years.
Investment A’s payback stretches into the fifth year and Investment B’s into the fourth.
Note that total income is not taken into account in this method. In fact Project C has the lowest total return over the 6 years.

12. Calculating the exact pay back period
In order to make back the £70,000
Investment we need:
All of the profits from years 1-4
Plus £10,000 of the £30,000 generated in year 5
The payback period is therefore 4 years plus 10,000/30,000
In Days
10,000/30,000 X 365 =
In Weeks
10,000/30,000 X 52 =
In Months
10,000/30,000 X 12=
Investment A
Initial Cost
£70,000
Estimated Profit Generated
Year 1
£10,000
Year 2
Year 3
£20,000
Year 4
Year 5
£30,000
Year 6
£40,000
Total
£130,000

13. Question
Project A
Project B
Initial Cost
£8,000
£6,000
Income
Year 1
£3,000
£5,000
Year 2
£4,000
Year 3
£9,000
Total
£17,000
£15,000
Which project should the company choose fi payback period is being used?

14. Answer Both projects have the same return over 3 years.
Project A has a payback of 2 years
Project B has a payback of 1 year 3 months
Therefore Project has the shortest payback time and should be chosen

15. Average Rate of Return

16. ARR- Average Rate of Return
The ARR method measures the net return each year as a percentage of the initial cost of the investment.
The formula for ARR is:
Average Annual Profit X 100
Initial Outlay

17. Example Project X Project Y Project Z Cost £50,000 £40,000 £90,000
Return:
Year 1
£10,000
£20,000
Year 2
Year 3
£30,000
Year 4
Year 5

18. Step 1- Calculate Total Net Profit
This is total profits over the life time of the investment with the initial investment deducted £70,000 - £50,000 = £20,000 for Project X.

19. Step 2 – Calculate Annual Profit
The next step is to calculate the net profit per annum by dividing the total net profit by the number of years the project runs for
£20,000  5 = £4,000 for Project X.

20. Step 3 – Calculate the ARR
Average Annual Profit X 100
Initial Outlay
For Project X
£4,000 x = 8%
£50,000

21. Overall Results – Calculate the ARR for Project Y and Project Z
Project X
Project Y
Project Z
Initial Cost
£50,000
Total Net Profit
£20,000
Net Profit per Annum
£4,000
ARR 8%

22. Overall Results… Which Project should be chosen?
Project X
Project Y
Project Z
Initial Cost
£50,000
£40,000
£90,000
Total Net Profit
£20,000
Net Profit per Annum
£4,000
£5,000
£8,000
ARR 8%
12.5 %
8.9%

23. Come back to this decision from the start of the lesson
Investment A
Investment B
Investment C
Initial Cost
£70,000
£100,000
£200,000
Estimated Profit Generated
Year 1
£10,000
£50,000
£20,000
Year 2
£40,000
£30,000
Year 3
Year 4
£60,000
Year 5
Year 6
Calculate the Payback and ARR for each of these Investments.
Which one do you think should be chosen? Why?

24. Task – Practice Questions
Answer the questions:
Payback and ARR Quick Questions
Pilgrims Choice (Payback and ARR)

25. The Higher Level Stuff
Net Present Value

26. Money now is more valuable than money later on…… Why?

27. Present Values
So $1,000 now is the same as $1,100 next year (at 10% interest)
We say the Present Value of $1,100 next year is $1,000

28. And on and on……
So…. Businesses might find it useful to know the Present Values of future profits they expect to make

29. Example
Investment A promises you $90,0 00 in 3 years, what is the Present Value?
To take a future payment backwards three years divide by 1.10 three times
So $90,000 in 3 years is:
$90,000 ÷ 1.10 ÷ 1.10 ÷ 1.10
$90,000 ÷ (1.10 × 1.10 × 1.10) = 1.103
$90,000 ÷ 1.331
$67,618 now
Question: What would the difference be if only a 5% interest rate was assumed?

30. Net Present Value
NPV is a method of investment appraisal that take the present value of future profits/cashflows into account rather than the nominal value
It therefore favours investments that bring in profits/cashflows more immediately
It considers overall profitability of investments at present values

31. Making decisions using NPV
Normally the project with the highest NPV will be chosen.
If the NPV is positive - cash benefits exceed cash costs - this means that the project will earn a return in excess of its cost of capital (the rate of interest/discounting used in the calculation).
If the NPV is negative - this tells the managers that the cost of investing in the project exceeds the present value of future receipts, and that it is not worth investing in it.

33. Example Question Year Project A Project B -250 1 +50 +200 2 +100 3
-250 1
+50
+200 2
+100 3
Assuming that the interest rate is 10%, calculate the NPV of both projects and decide which one would be the better investment
Use the discount table

34. Example Answers (Assuming an interest rate of 10%)
Project A
Returns Discount Factor
Year 0 -£250
Year 1 +£50
Year 2 +£100
Year 3 +£200
Present Value
1.00
-£250
0.91
£45.50
0.83
£83
0.75
£150
Net Present Value = £28.50

35. Example Answers (Assuming an interest rate of 10%)
Project B
Returns Discount Factor
Year 0 -£250
Year
Year 2 +£100
Year 3 +£50
Present Value
1.00
-£250
0.91
£182
0.83
£83
0.75
£37.50
Net Present Value = £52.50

36. Question (All values in £)
Year
Investment A
Investment B
-800
-500 1
300
100 2
150 3
250 4 5
Calculate the Net Present Value for these two investments assuming a discount factor of 8%

37. Answers 1.00 0.89 0.80 0.71 0.64 0.57 Year Investment A
Discount Factor
Present Value
-800
1.00 1
300
0.89
267 2
0.80
240 3
0.71
213 4
0.64
192 5
0.57
171
NPV=
283

38. Answers
Year
Investment B
Discount Factor
Present Value
-500
1.00 1
100
0.89 89 2
150
0.80
120 3
250
0.71
177.50 4
0.64
160 5
300
0.57
171
NPV=
217.50

39. Interpretation
Purely based on NPV Investment A should be chosen with a return of £283 against a return of £ for investment B
However if we look at the return as a % of the initial investment Project A = 35% whereas Project B = 44%.
The company may wish to look at non-financial factors to help them make the decision

40. Task - Questions Answer the questions: NPV Quick Questions
Pilgrims Choice (NPV)

41. Evaluating Each method….

42. Task Each group take one method of Investment Appraisal.
Try to come up with your own list of advantages and disadvantages of each method.
Payback
ARR
NPV

43. Payback Period Advantages and Disadvantages
it is easy to calculate and understand
its use emphasises liquidity, because the calculations are based exclusively on cash flows
it helps managers to reduce risk by selecting the project which recovers its outlay most quickly
Limitations
cash earned after the ‘payback’ is not taken into account in the decision to invest
it completely ignores the potential profits that can be earned since the criterion is the speed of repayment
Short-termism
Doesn’t take into consideration decreasing value of money

44. Average Rate of Return Advantages and Limitations
it is simple to calculate and understand
it shows clearly the profitability of an investment project
it allows a better comparison of alternative projects, because it is related to the size of the initial investment outlay
Can be directly compared to bank interest rates
it disregards the fact that money received at a later date does not possess the same real value as money received today

45. Net Present Value Advantages and Limitations
Net Present Value takes into account that interest rates affect the present value of future income.
future cashflows are discounted by a ‘discount factor’ that the firm decides on and is affected by the rate of interest
It is time consuming and more difficult to calculate than payback and ARR
Choosing the right discount factor can be difficult

46. What else should be taken into account?
Qualitative Factors

47. Introduction
Investment Appraisal provides a scientific decision-making technique for managers
However financial data do not always show the full picture, so a firm must not base its decisions solely on investment appraisal results.
Other factors to be considered, and their relative importance will vary according to circumstances

48. Key Qualitative Factors
The aims of the organisation
Liquidity position
Reliability of data
Production Requirements
Personnel
The economy
Image/public relations
Subjective factors
A profit making firm will emphasise the results of an investment appraisal, companies with liquidity problems may deem payback to be the most appropriate method. A firm that places a high value on social issues might reject a profitable investment if it is considered to exploit the workforce or damage the environment.
Future costs and incomes rely on the accuracy of market research and an ability to predict external changes. Particularly for investments of a longer duration, predictions can be wildly inaccurate
Projects providing a high return on investment often involve risk. A firm may choose to choose a lower but more certain return
The company must consider the compatibility of any new machinery with its existing range. A firm may be reluctant to deal with a new supplier if it enjoys a good service from its existing supplier. The availability of spare parts, the promise of JIT deliveries and general benefits arising from the goodwill of another company may prove to be more important than a minor financial gain
Will any new equipment or method suit the companies staff? The ease of use, level of training needed, safely of the machine, impact on the number of staff employed are all factors that should be considered.
Interest rates will have a major impact. If interest rates are rising, any investment will be required to generate greater profit. Future economic changes such as a boom or a recession must be considered when making predictions about future costs and revenues
The firm should consider the influence of a project on its image and public relations.
Ultimately individuals, who have their own personal preferences take investment decisions. In the relocation of a factory managers may take into consideration the impact on their own family and their own views on the attractiveness of an area

49. Timed IB Question – 18 minutes
Answer the Altair Incorporated question
(SL students only have to do ARR and Payback. Q1 will only be worth 5 marks and only 13 minutes will be given)

50. Discount Table Years Ahead 6% 8% 10% 12% 15% 1.00 1 0.94 0.93 0.91
1.00 1
0.94
0.93
0.91
0.89
0.87 2
0.86
0.83
0.80
0.76 3
0.84
0.79
0.75
0.71
0.66 4
0.74
0.68
0.64
0.57 5
0.62
0.50