INVESTMENT APPRAISAL NON DISCOUNTING By Lucky Yona

INVESTMENT APPRAISAL An attempt to assess the financial feasibility of an investment option Quantitative techniques to assess the attractiveness of different capital projects. Projects suitable for investment appraisal Investment in new cost saving equipment Investment in New Capacity Investment in New premises Marketing campaign Investment in another firm, merger or aquisition

CHARACTERISTIC OF CAPITAL INVESTMENT DECISION Involve long term commitment of capital sums Benefits are received as a stream stretching long into the future Are almost impossible to reverse without accepting a significant loss Containing an element of uncertainty Costs are incurred today but benefit occurs in the future. They affect future profitability and the firm’s very existence.

SHORT AND LONG TERM DECISIONS Short Term Long Term Time Span 1-2 Years 2 Years + Topic Current Operations Future Capacity Nature Operational Strategic Level of Spending Small/Medium High External Factors Not so Important Very Important

FACTORS TO TAKE INTO CONSIDERATION Initial cost of the asset The Expected benefits from the Asset The Operating costs of the asset The expected life of the asset Timing of the Benefit The risk involved The alternative forms of investment Qualitative as well as quantitative factors.

INVESTMENT APPRAISAL INVOLVES A COMPARISON OF COST AND BENEFITS Investment appraisal considers the benefits of an investment decision in relation to the anticipated costs. The expected future streams of additional benefit ( expressed in cash terms take the form of increase revenues and/reduced costs. The cost include the initial outlay and the running costs.

EXPANSION V/S COST REDUCTION PROJECTS In some cases, capital is designed to increase capacity. Here the benefit or veturn comes in the form of additional sales revenue (net of operating costs) Other investment projects have designed to reduce costs e.g.labour saving equipment have the net comes in the form of savings.

All techniques of investment appraisal are designed to answer the question: is it worth while going ahead with the proposed investment. Pay back – the time it takes to recover the cost of an investment. Accounting rate of return average annual rate of return as a % of the cost of the investment. The non discounting methods

Payback. A simple method of investment appraisal. It focuses on the length of time needed to recover the capital costs of an investment. The payback period is the number of years it takes the cash inflows from a capital project to equal the cash outflows. A firm may have a target payback period above which projects are reject.

What is the payback period. The time it takes for an investment to pay for itself. The time it takes the cash inflows from a capital investment project to equal the cash outflows. It is usually expressed in terms of years or months. It is calculated by adding up annual returns from an investment until the cumulative total equals initial cost.

Decisions based on payback. Accept the project if the payback period is less than the target period. Reject the project if the payback period is more than the target period. In the case of competing investments projects rank projects by payback and accept the project with the shortest payback period (provided it meets the target payback period)

EXAMPLE

Notes to the example. The cash inflow is the is the revenue minus operating costs or the new savings made on the project. If the exact pay back is returned it must be assumed that cash flows ave constant throughout the year.

Advantages of the payback method. Easy to calculate, use and understand. Stresses cash flow and speed of return. It recognizes that cash received early is an asset’s life, is preferable to cash received later. It takes account to how quickly the firms recoups its investment –short payback means less risk. Payback favors projects with an early return. For a firm with cash problems an early return is preferred. Useful where the product is likely to have short life span. Can be used as a quick way of screening potential investment projects.

Disadvantages of the pay back method. Takes no account of the overall, long term profability of a project. Ignores the timing of cash flows within the payback period and after the payback period. Ignores the time value of money. Is not a measure of profitability. Does not help to choose between alternative projects with the same payback period. May lead a business to focus only on projects with a quick return. Discriminates projects which involve a long payback period

Accounting rate of return. Measures the % return the project achieves over its life in terms of profitability. Also known as the average rate of return. Expresses annual average profit as % of initial investment over the life of an investment. It is a form of return on a capital employed. ARR = Average annual profit X100 Average investment The ARR is based on anticipated profit rather than forecasted cash flows.

EXAMPLE See Text Book Page

Criteria's for Projects Selection Accept all those projects whose ARR is higher than the minimum rate established by the management. Reject those projects which have ARR less than the minimum rate. Rank the project as No 1 if it has highest ARR and lowest rank will be assigned to the project with the lowest ARR.

Merits- ARR Simple to understand and Use. It incorporates the entire stream of income in calculating the project profitability. It can be used as the performance measure.

Shortcomings It uses accounting profits, not cash flows, in appraising the projects. Profits has subjective elements, is subject to accounting conventions and is notappropriate for investment appraisal purposes as the cash flows generated by the project are ignored in computation. The averaging of income ignores the time value of money. It may lead to unprofitable allocations of capital. There is no universally accepted method of calculating ARR.