1. GCE PROFESSIONAL BUSINESS SERVICES AS 3
Investment Appraisal

2. 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

3. 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

4. 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

5. 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

6. 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.

7. 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)

8. 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)

9. 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

10. 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

11. 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

12. 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