Investment appraisal – Using quantitative analysis to analyse whether a capital investment is worthwhile – For strategic or medium term objectives not tactical decisions. Can link to functional objectives, as follows Functional objectiveExample of investment decision to achieve objective Marketing: increase market share by 2% Open new outlets or factories, introduce new products Finance: increase ROCE from 15% to 20% Build new factory/introduce new efficient machinery People: reduce labour turnover by 20% Invest in training (leading to higher productivity/morale/responsibility) Operations: identify best locationInvestment appraisal to find lowest cost site for production

Methods of Investment Appraisal Three methods – Payback How many years and months before the initial cost of the investment is paid back – Average rate of return (ARR) The average annual profit as a percentage of the initial investment. Comparable with ROCE – Net present value Total return from an investment in today’s money (taking into account that money received in the future is worth less than money now)

Payback Measures the length of time it takes to pay back the original cost of an investment Look at initial investment, then annual cash inflows and outflows, for example with a printing machine costing £750,000 Use the information in the first table to complete the second £Machine A Initial cost750,000 Inflows: Year 1180,000 Year 2220,000 Year 3250,000 Year 4250,000 Year 5275,000 Maintenance10,000 per year Year (£)Cash inCash outNet cash flow Total Note the initial investment is deemed to take place in year 0

Payback When does the investment of £750,000 get paid back? Add up all the cash flows until you have enough to cover the initial investment After 3 years, net cash flow is £620,000, so not enough – short by £130,000 At the end of 4 years net cash flow is £860,000, so the investment is paid back in the 4 th year When in the 4 th year? – Net cash flow in year 4 is £240,000, or £20,000 per month (assume spread evenly) – Require £130,000, so need £130,000/£20,000 which is 6.5 months – So payback is 3 years 6.5 months Year Cash out (£) Cash in (£) Net cash flow (£) 0750,0000(750,000) 110,000180,000170, ,000220,000210, ,000250,000240, ,000250,000240, ,000275,000265,000 Total800,0001,175,000375,000

Payback If cash flows are constant (eg £360,000 per year), then simply take sum invested/net cash flow. In this case would be £750,000/£360,000 = 2 years and 1 month May be given outflows and inflows, or costs and revenues. Need to work out net cash flow or net return, and put into a table Always put investment in Year 0, then work out net inflow for the following years Nearly always based on a finite time period – Most machinery is expected to last a certain time (and is depreciated) – Note that whilst questions are based on a finite period, some investment may add value over a longer period, eg opening a new store

Payback example A local garage is considering buying a machine which can refill (re-gas) the air-conditioning units of customer cars. The estimated costs and revenues are as follows: The garage estimates the number of customers requesting the air- conditioning service to be: Calculate the payback period Cost of machinery£10,000 Cost of gas per service£15 Wages and other costs per service£15 Price charged per service£80 Year 140 Year 260 Year 360 Year 460 Year 540 Year 630

Payback example answer First need to fill in cash out and cash in, complicated by needing to calculate After 3 years cumulative net cash flow is £8,000, so short by £2,000 After 4 years total is £11,000 so paid back during this year In year 4 cash flow is £3,000 or £250 per month, so needs £2,000/£250 months Payback is therefore 3 years 8 months Year Cash out (£) Cash in (£) Net cash flow (£) Cumulati ve 010,0000(10,000) 11,2003,2002,000(8,000) 21,8004,8003,000(5,000) 31,8004,8003,000(2,000) 41,8004,8003,0001,000 51,2003,2002,0003, ,4001,5004,500 Total18,70023,2004,500

Average rate of return We can calculate when an investment is paid back, but does that make it worthwhile? Really looking for a high rate of return on the investment (remember Unit 2????) Need to make sure the return covers the cost of borrowing if using a bank loan, or if there are other better investments Use average rate of return (ARR) ARR (%)= x 100 (Total net return/number of years) Initial investment

ARR Calculate for printing machine Calculate for air-conditioning machine

Net present value (NPV) Quite sophisticated, and only larger businesses will use this ARR does not take into account when the cash flows take place Are cash flows received in 5 years worth the same as cash flows or payments this year? Idea is that £1 today has more value than £1 in the future – This is because of the opportunity cost of money – can do something with the £1, such as earn interest. Also, money today is certain, whilst there is always risk about receiving money in the future – For example, at an interest rate of 10%, £100 becomes £110 after 1 year – In this case, the present value of £110 received in a year’s time is £100

NPV If you could earn 10% interest by putting money in the bank, which of the following would you prefer: – £1,000 today or £1,150 in 2 year’s time? – £50 today or £65 in 3 year’s time? – £1, % of £1,000 is £1,100 in a year’s time, – £1, % of £1,100 is £1,210 in 2 year’s time – Formula is £1,000 x (1 + 10%) x (1+10%) or £1,000 x (1+10%) 2 which is £1,000 x – Advanced: general formula is £1 becomes £1 x (1 + r) n where r is the rate of interest, and n is the number of years

NPV So putting in reverse, what is £1,150 worth in today’s money – what is the present value of £1,150 in 2 year’s time with an interest rate of 10% £100 today = £100 x in 2 years, so divide both sides by – £100 ÷ today = £100 in 2 years – £100 ÷ 1.21 today = £100 in 2 years – £83 today= £100 in 2 years So the present value of every pound in 2 year’s time is £0.83 today, which means £1,150 in 2 year’s time is worth £1,150 x 0.83 = £950 10% is called the discount rate and 0.83 is called the discount factor Present value is future net cash flow times the discount factor Exam questions will give the discount factor you should use

NPV example Simple example: – Invest in a machine for £100m, with the following cash inflows and outflows, and with the following discount factors (based on a discount rate of 10%): YearCash out (£m)Cash in (£m) Net cash flow (£m) Discount factorPresent value (£) 0100(100) Total Net cash flow times discount factor equals present value

NPV practice NPV of printing machine YearCash out (£)Cash in (£)Net cash flow (£) Discount factorPresent value (£) 0750,0000(750,000)1 110,000180,000170, , ,000220,000210, , ,000250,000240, , ,000250,000240, , ,000275,000265, ,300 Total800,0001,175,000375,00086,500

NPV practice NPV of printing machine YearCash out (£)Cash in (£)Net cash flow (£) Discount factorPresent value (£) 0750,0000(750,000)1 110,000180,000170, , ,000220,000210, , ,000250,000240, , ,000250,000240, , ,000275,000265, ,300 Total800,0001,175,000375,00086,500

NPV NPV is particularly useful comparing alternative projects/investments as follows Can also use different discount rates (discount factor) to take into account riskiness of projects £mProject 1Project 2 YearNet cash flowDiscount factorPresent valueDiscount factor 0(100) Total ARR30%25% Payback3 years1 year 4 months

The 3 methods AdvantagesDisadvantages All Scientific methodology rather than guessworkRelies on forecasts, which may be inaccurate – particularly the further into the future they are made Payback Easy to understand Easy to calculate, particularly useful if comparing many projects By emphasising the speed of return it is popular with firms operating in changing markets Ignores cash flows which take place after the payback period has been reached Hard to establish a payback period – factories may take longer to pay back than a marketing campaign, but still be valuable Values future cash flows the same as present ones ARR Easy to calculate The result can be compared with the next best alternative, eg interest rate Shows true profitability of an investment A bit harder to calculate than payback Values all cash inflows and outflows the same, whenever they take place (including very uncertain long term forecasts) NPV Only method which considers the time value of money Only method which gives an answer – positive NPV means a project is worthwhile Cash flows a long time in the future are uncertain (risky) and are given less weight Conceptually difficult to understand which bosses may mistrust Hard to calculate Depends on the choice of discount rate – which may be arbitrary