2-INVESTMENT-APPRAISAL.pdf

Edexcel International A Level Business 333 Decision-making techniques 2 INVESTMENT APPRAISAL Revisionstation From the specification a) Simple payback. b) Average (accounting) rate of return. c) Discounted cash flow (net present value only). d) Calculations and interpretations...

Edexcel International A Level Business 333 Decision-making techniques 2 INVESTMENT APPRAISAL Revisionstation From the specification a) Simple payback. b) Average (accounting) rate of return. c) Discounted cash flow (net present value only). d) Calculations and interpretations of figures generated by these techniques. e) Limitations of these techniques. Starter You own a business. You have a meeting today with your Marketing Director, your Production Manager and your Research Team Manager, they know you have £1million retained profit which can only be spent on one project. They each pitch their idea to you, which do you choose: Project 1: A New warehouse which will mean the business can double the capacity Project 2: A new marketing campaign which will double sales Project 3: Research into new products which will give the business an edge in a highly competitive technical market place Investment appraisal defined Investment appraisal is a method of evaluating investment projects to determine whether they are profitable. It enables the business and its investors to compare projects which are usually profit maximisation and efficiency. Investment appraisal – planning process Investment appraisal is the planning process used to determine whether the long term investments will give the best return. Projects such as; new machinery new premises research and development projects Investment appraisal – decision making Proposal 2: new machinery Proposal 1: new premises Proposal 3: Research A business will have lots of ideas for projects, and proposals of ways to grow their business. The business will only have a finite amount of money and so perhaps only one project will get the funding it needs to go ahead. Investment appraisal is used to work out which project should get the funds. Simple Payback  Payback - explained A business needs to decide Cash Proposal Proposal Proposal Proposal flows 1 2 3 4 which project or proposal to (£000s) invest in. Year 0 -£120 -£95 -£80 -£160 It cannot afford all four so it will Year 1 have a number of methods to £80 £10 £30 £30 work out which one it should Year 2 £60 £40 £40 £50 spend the money on. Year 3 £40 £40 £30 £90 The table starts at year 0 Year 4 because this is the amount £20 £60 £30 £80 Year 5 invested in the project at the £40 £50 £20 £60 start.  Very simple Payback calculation Cash Proposal Proposal Proposal Proposal Lets look at proposal 1 flows 1 2 3 4 Year 0 is the investment so it will (£000s) cost £120 to get the project Year 0 -£120 -£95 -£80 -£160 going Year 1 £80 £10 £30 £30 When will this be paid back? Year 2 £40 £40 £40 £50 Year 3 In year 2 the project made £80 £40 £40 £30 £90 Year 4 from year one plus £40 from £20 £60 £30 £80 Year 5 year 2. £40 £50 £20 £60 The project pays back in year 2 Obviously this is too simple – so next slide find out what happens when its part way through a year  Payback calculation Lets look at proposal 2 Its going to cost the business £95 to get this project up and running Cash Proposal Proposal Proposa Proposal flows 1 2 l3 4 Year 1 the project makes £10, (£000s) Year 2 the project makes £40 Year 0 Year 1 -£120 -£95 -£80 -£160 Year 3 the project makes £40 £80 £10 £30 £30 Year 2 £40 £40 £40 £50 So far it has paid back £90 Year 3 £40 £40 £30 £90 Now we need £5,000 more from Year 4 £20 £60 £30 £80 Year 5 year 4 so: £40 £50 £20 £60 Final answer is proposal 2 5,000 =1/12 year =1 month _______ will payback in 3 years 60,000 and 1 month Calculate the payback periods Cash inflows (£000s) Proposal 1 Proposal 2 Proposal 3 Proposal 4 Year 0 -£120 -£95 -£80 -£160 Year 1 £80 £10 £30 £30 Year 2 £40 £40 £40 £50 Year 3 £40 £40 £30 £90 Year 4 £20 £60 £30 £80 Year 5 £40 £50 £20 £60 When does the project payback? Calculate the payback periods Cash inflows (£000s) Proposal 1 Proposal 2 Proposal 3 Proposal 4 Year 0 -£120 -£95 -£80 -£160 Year 1 £80 £10 £30 £30 Year 2 £40 £40 £40 £50 Year 3 £40 £40 £30 £90 Year 4 £20 £60 £30 £80 Year 5 £40 £50 £20 £60 When does the project payback? 3 years and 1 2 years and 4 2 years and 11 2 years month months months Payback — advantages Simple to use. Especially suitable for those businesses which have cash flow problems. They should choose the project which pays back more quickly than others. The method is also useful when technology changes rapidly, as it’s important to recover the cost of investment before a new model or equipment is designed. ARR ARR explained Payback is very simplistic tool and only looks at when the project will pay back and does not take into account rate of return on the investment So a business can also use the ARR system which looks at the average rate of return of the projects The rate of return can be compared against a savings account or the rate of return of other investments, which helps the business to measure if the project has been a good use of the money available ARR calculation steps in brief 1. Add up the cash inflows for all the years from 1 onwards 2. Minus the cost of the project 3. Divide by the number of years the project runs for 4. Divide by the cost of the project x 100 5. Round your answer to 2 decimal places and express as a percentage % e.g. 11.29% ARR method Lets look at proposal 3 1. Add up all the cash inflows from years 1-5 = £150,000 Cash Proposal Proposal Proposal Proposal 2. Then minus the original cost of the project Inflows 1 2 3 4 (£80,000) = leaves £70,000 (£000s) 3. Then divide this by the number of years the project runs for : Year 0 -£120 -£95 -£80 -£160 Year 1 £80 £10 £30 £30 70,000 _______ = 14,000 Year 2 £40 £40 £40 £50 5 Year 3 £40 £40 £30 £90 Year 4 £20 £60 £30 £80 4. Now take this figure and divide it by the Year 5 £40 £50 £20 £60 cost of the project: Need to compare this % with the other 14,000 projects to see which would give the _______ X 100 17.5% = highest average rate of return 80,000 Calculate ARR Cash Inflows (£000s) Proposal 1 Proposal 2 Proposal 3 Proposal 4 Year 0 -£120 -£95 -£80 -£160 Year 1 £80 £10 £30 £30 Year 2 £40 £40 £40 £50 Year 3 £40 £40 £30 £90 Year 4 £20 £60 £30 £80 Year 5 £40 £50 £20 £60 ARR  Calculate ARR Cash Inflows (£000s) Proposal 1 Proposal 2 Proposal 3 Proposal 4 Year 0 -£120 -£95 -£80 -£160 Year 1 £80 £10 £30 £30 Year 2 £40 £40 £40 £50 Year 3 £40 £40 £30 £90 Year 4 £20 £60 £30 £80 Year 5 £40 £50 £20 £60 ARR 16.67% 22.11% 17.50% 18.75% Your business will want the highest rate of return so proposal 2 would be the one that gets the green light for the funding ARR — advantages It shows clearly the profitability of an investment project. Which allows the business to compare among different projects, as well as between projects and the saving bank. It’s easier to identify the opportunity cost of investment. NPV (net present value/DCF) NPV This is the net present value and it takes into account that money in the future is not worth what it is today – so it adds in a discount table to make it more realistic NPV calculation Cash inflows Proposal 1 Discount Present Lets look at proposal 1 (£000s) table 20% value First take a discount table, in this example it is a 20% discount each Year 0 -£120 1.00 -£120 year, to make the profit figure Year 1 more realistic as money in the £80 0.83 66.4 future is worth less than it is now Year 2 £40 0.69 27.6 Year 3 Multiply each cash inflow by the £40 discount, this gives the present Year 4 £20 value column Year 5 £40 NPV is all the PV values added Total together then minus the initial cost You will be given the discount table in the In this example the NPV is exam– you do not have to memorise these _______ figures Calculate the NPV (discount rate=20%) Cash Proposal 1 Proposal 2 Proposal 3 Proposal 4 Inflows (£000s) Year 0 -£120 -£95 -£80 -£160 Year 1 £80 £10 £30 £30 Year 2 £40 £40 £40 £50 Year 3 £40 £40 £30 £90 Year 4 £20 £60 £30 £80 Year 5 £40 £50 £20 £60 NPV value NPV — advantage Unlike the previous two, correctly accounts for the value of future earning by calculating present value. The discount rate can be changed as risk and conditions in financial markets change. Limitations Limitations of Investment Appraisal Payback limitations; cash earned after the payback period is ignored; only looks at speed of payback and dopes not look at profitability ARR limitations; Does not take into account the effects of time on the value of money NPV limitations; Very complex; results dependent on rate of discount used, the higher the rate the more likely it is that the project will be rejected. Sample practice questions Case study for question 1  Sample question 1 Old IAL spec sample questions Knowledge 2 Answer sample question 1 Case study for question 2  Sample question 2 Old IAL spec sample questions Level 1 Level 2 Level 3 Level 4 1-2 3-4 5-7 8-10 Answer sample question 2 Glossary ARR; Average rate of return, a simple method of calculating which project offers the best rate of return on an investment, compare with bank rate of 5% for savings NPV; Pet present value, discounts the future value of money, taking into account interest rates and time Payback; simple method of working out which project proposal will pay the investors back the soonest