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Key Facts For Investment Appraisal

How to evaluate Payback, NPV and ARR

Date : 25/10/2021

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Christina

Uploaded by : Christina
Uploaded on : 25/10/2021
Subject : Business Studies

Investment Appraisal the key facts

Payback

Payback is the simplest method of investment appraisal.

The payback period is the time it takes for a project to repay its initial investment.

Payback is used measured in terms of years and months, though any period could be used depending on the life of the project (e.g. weeks, months).

Payback focuses on cash flows and looks at the cumulative cash flow of the investment up to the point at which the original investment has been recouped from the investment cash flows.

Advantages of Payback

Simple and easy to calculate + easy to understand the results

Focuses on cash flows good for use by businesses where cash is a scarce resource

Emphasises speed of return may be appropriate for businesses subject to significant market change

Straight forward way to compare competing projects

Disadvantages of Payback

Ignores cash flows which arise after the payback has been reached i.e. does not look at the overall project return

Takes no account of the time value of money

May encourage short-term thinking

It assumes that all cash flows arise equally every month (may not, especially for a seasonal business)

Does not actually create a decision for the investment

Net Present Value - NPV

Net present value ("NPV") uses an important concept in investment appraisal discounted cash flows.

NPV recognises that there is a difference in the value of money over time

This is the opportunity cost of money and also called the time value of money

A positive NPV for a project suggests that the investment project should go ahead

A negative NPV would suggest that a project should be rejected

If choosing between 2 or more projects, choose the project with the highest NPV

Advantages of NPV

Takes account of time value of money, placing emphasis on earlier cash flows

Looks at all the cash flows during the whole the life of the project

Use of discounting reduces the impact of long-term, less certain cash flows

Has a decision-making mechanism reject projects with negative NPV

Maybe most helpful for projects with very long lives

Disadvantages of NPV

More complicated method users may find it difficult to understand

Difficult to select the most appropriate discount rate may lead to good projects being rejected

The NPV calculation is very sensitive to the initial investment cost

Accounting Rate of Return ARR

Business investment projects need to earn a satisfactory rate of return if they are to justify their allocation of scarce capital. The ARR looks at the total accounting return for a project to see if it meets the target return (often referred to as a "hurdle rate"). Rather similar to ROCE.

ARR = Average profit per year / cost of investment X 100

ARR uses PROFITS rather than cash flows

So, if a question gives you NET CASH FLOWS:

add up all the net cashflows

deduct the cost of the investment

by the number of years (or other time periods)

The resulting figure then approximates AVERAGE PROFIT per year

(i.e. in the accounts the investment would have been depreciated over the life of the investment)

A key question will be - How does this return compare with the target return for other investments in this business? If it s much lower, it should be rejected as it may reduce the overall return of the business

Advantages of ARR

ARR provides a percentage return which can be compared with a target return

ARR looks at the profitability over the whole life of the project

Focuses on profitability a key issue for shareholders

Disadvantages of ARR

Does not take into account cash flows only profits (they may not be the same thing)

Takes no account of the time value of money

Treats profits arising late in the project in the same way as those which might arise early

Tips when deciding which technique to recommend in exam Qs

Think about who the interested stakeholders are:

Payback NPV both use cashflow rather than profit so more useful for start ups or a business with cashflow issues or liquidity problems. Will a bank (loan) or shareholders (share capital) make the cash available if the business already has cashflow issues?

ARR is the only one to use profit so this is the best to use if the business is trying to convince shareholders or new investors that this project is worth the investment.

Think about the qualitative factors as none of the techniques take these into account:

Examples of Non-financial Factors (Qualitative Factors):

Corporate image

Corporate aims and objectives

Environmental and ethical issues

Industrial relations e.g. technology means employees may be made redundant

Distance from customers for deliveries

Availability of finance

Think about whether the long-term position is important:

Only NPV and ARR consider returns over the whole life of the project

Think about the cashflow situation:

If cash/finance is a problem, say for a start up, speed of pay back may be the most important issue

Think about the uncertainty of predicting future cash flows profits:

Only NPV takes into consideration the time value of money by using the discount factor, so that cash flows in the future are worth less than today

Sensitivity Analysis:

A technique that uses variations in forecasts to allow for a range of outcomes

A disadvantage is that it can only consider one variable at a time

Ties in well to Decision Trees, Critical Path Analysis and Break Even as well

However, still only as useful as the accuracy of the information available and how well the potential results are analysed and how well the plan is implemented

Is the finance available?

Benchmarking:

A business can measure its performance against the established industry standards or against another similar successful business in the same sector

Risk Uncertainty:

Risk = the chance something bad or unexpected will happen

Examples of why forecasts maybe inaccurate:

Timescales

New markets

Competitor s reactions

Costs rise e.g. £ fell after Brexit so import costs rose

This resource was uploaded by: Christina