GCE PROFESSIONAL BUSINESS SERVICES AS 3 Investment Appraisal

Learning Outcomes Students should be able to: demonstrate understanding of the following methods of investment appraisal for financial decision making: Payback Net Present Value (NPV) conduct an investment appraisal in a given business context evaluate the outcomes of an investment appraisal and make recommendations for investment decision making evaluate the methods of investment appraisal a professional business services firm can use with a client when advising on financial decision making

Investment Appraisal - Definition An analysis of alternative investment projects using standard investment appraisal techniques in order to determine the investment most likely to meet organisational objectives This is usually undertaken with reference to the following techniques: Payback Net Present Value Investment Appraisal

Reasons for Investment Appraisal Provides detailed analysis of options to managers and help them make decisions on capital investment projects Enables projects to be evaluated Can compare competing projects Decisions are based on financial criteria Enables assumptions to be validated regarding cash flows, timing and outcomes

Payback Method The time it takes for an investment to repay the initial outlay of capital If Cash flows are even, then month of payback = Income required Cash flow per month

Payback Period If cash inflows are uneven, it is necessary to calculate the cumulative net cash flow for each period and then use the following formula: Payback Period = A + B C Where: A is the last period with a negative cumulative cash flow; B is the total value of cumulative cash flow at the end of the period A; C is the total cash flow during the period after A. Decision Rule: Only invest in the project giveing the shortest payback period.

Net Present Value (NPV) Method Net Present Value (NPV) takes into consideration the time value of money. Future cash flows are discounted or reduced by a certain percentage (eg 5%, 10%) to reflect their lower value, usually on an annual basis. It is assumed that cash flows occur evenly throughout the project Also known as Discounting, or Discounted Cash Flow (DCF)

Net Present Value (NPV) Method Determine the initial outlay Determine the annual cash flows Determine the discount factor to be applied Multiply each annual cash flow by discount factor to give a Present Value (PV) Sum all Present Values to determine the Net Present Value Decision Rule: invest in the project which gives the highest positive Net Present Value (NPV)

Payback Period Advantages Limitations Easy to understand Simple to use Good for screening projects Indicates how long money is at risk Does not take into account any cash flow after the payback period Overall profitability of the investment is not considered Does not consider the current value of the cash

Net Present Value (NPV) Method Advantages Disadvantages Adjusts for financial risk – considers the time value of money More robust method compared to Payback Can consider various scenarios More complex to calculate than payback Results are easy to misread Difficult to estimate the discount rate accurately Difficult to estimate the annual cash flow each year

Interpreting Outcomes Investment appraisal methods provide a mathematical appraisal – but final decision may be influenced by other factors: Management objectives Capital available Opportunity cost Length of investment Management attitude to risk Non-financial objectives of the business/client

Learning Check Can you: demonstrate understanding of the following methods of investment appraisal for financial decision making: Payback Net Present Value (NPV) conduct an investment appraisal in a given business context evaluate the outcomes of an investment appraisal and make recommendations for investment decision making evaluate the methods of investment appraisal a professional business services firm can use with a client when advising on financial decision making