Investment Apprasial

BUSINES
S&MANA
GEMENT
Investment Appraisal
by: Shadi A. Razak 1
Accounts
and Finance

Objectives
• Understand what investment means.
• Recognize the importance of investment
appraisal to the business.
• Explain different techniques to apprise an
investment and calculate its payback period
• Evaluate the net value of an investment and
its impact on the appraisal process.

Structure
• Introduction
• Investment Appraisal
• Quantitative Techniques
• Qualitative Techniques

Finance
INTRODUCTION

Finance
INTRODUCTION
The management of the business
capital, investment and assets to
inform stakeholders about the
business performance and
monetary profile

Finance functions
INTRODUCTION
Assessment
Acquisition
Handling
Accounting
Manage the business
finances and produce
financial statements
discuss the business
long term monetary
performance
Manage the business
day-to-day accounts and
produce accounting
statements, which
discuss business cost and
profit

Finance and Accounting
INTRODUCTION
Finance
• The
management
of the business
capital and
investments
Accounting
• The control
and
management
of the business
day to day
operations

•
INTRODUCTION
Cash invested in
• Factory building
• Machinery
• IT systems
Cash spent on
• Daily business
processes:
• Office administrations
• Energy costs
• Salaries
• Raw materials

INTRODUCTION
Capital Revenue
Source: http://www.cleantechcapitaladvisors.com/wp-
content/themes/cleantech/img/practices-capital.jpg
Source: http://www.mindupstudios.com/wp-
content/uploads/2014/09/revenue.png

• Long term non-current assets, which have an
economic life in business.
• These assets are acquired with intend to be
kept and not transformed into products or
sales.
Capital
INTRODUCTION

• Business try to use their capital to:
– Increase production capacity
– Replace outdated, broken, or worn out
equipments
– Deploy improved process or technology
– Comply with changing regulations and quality
standards
Capital
INTRODUCTION

• Has to address:
– Scarcity of finance in business
– Availability and viability of different sources of
finance
– Assess the risk of the investment
– Assess the investment return
Capital expenditure decision
INTRODUCTION

Investment appraisal
• The process of analysing the viability of an
investment project.
INTRODUCTION INVESTMENT APPRISEAL
Source: http://pd.mia.org.my/wp-
content/uploads/2014/03/Investment-appraisal-21-600x399.jpg

Investment appraisal
• Quantitative techniques: assess financial
feasibility of the project.
• Qualitative techniques: assess the non-
financial issues that impacts the investment
INTRODUCTION INVESTMENT APPRISEAL
Source: http://pd.mia.org.my/wp-
content/uploads/2014/03/Investment-
appraisal-21-600x399.jpg

Types of quantitative techniques
• Payback Period
• Average Rate of Return (ARR)
• Internal Rate of Return (IRR)
• Profitability Index
• Net Present Value (discounted cash flow)
INTRODUCTION INVESTMENT APPRIASAL QUANTITATIVE TECHNIQUES

Required information
• Initial capital cost investment
• Estimated life expectancy: life time in years or months
• Residual value of investment: what the assets cost at
the end of their life cycle
• Forecasted net returns or net cash flow from the
project: expected returns of investment – annual running
cost

Required information
INTRODUCTION
Source: http://www.tutor2u.net
INVESTMENT APPRIASAL QUANTITATIVE TECHNIQUES

Payback period
INTRODUCTION
The length of time taken
to pay back the original
capital cost of the
investment
Requires information
on the returns the
investment generates

Payback period
• Could occur during the year.
• Can be calculated
INTRODUCTION
Duration x Initial Investment
Payback = ------------------------------------------
Total Cash Received

Payback period
• Cost of machine = £500,000
• Annual cash flow = £250,000
• Calculate this project payback period.
INTRODUCTION
Years Income
Year 1 250,000
Year 2 250,000
Year 3 250,000

Payback period
• Cost of machine = £500,000
• Annual cash flow = £250,000
• Payback period = 36 X 500,000 / 750,000 = 24
months = 2 years
INTRODUCTION
Years Income
Year 1 250,000
Year 2 250,000
Year 3 250,000

Payback period
INTRODUCTION
• Can be identified
Source:http://www.tutor2u.net

Payback period
INTRODUCTION
» Simple and easy to
calculate
» Focus on cash
» Suitable for short term
decision
» Useful for rapidly
changing markets
» Ignores cash-flow
after payback has been
reached
» Disregards time value
of money
» Encourage short-term
thinking

Average rate of return (ARR)
INTRODUCTION
Compares the return (profit) generated
by the investment with the cost of the
investment
Source: http://cnafinance.com/wp-content/uploads/2015/03/Average-Rate-of-Return.jpg

INTRODUCTION
Source: http://cnafinance.com/wp-content/uploads/2015/03/Average-Rate-of-Return.jpg
ARR =
Initial cost of investment
Average annual return ( profit ) *
* Net cash-flow
X 100

• Investment (Live) is expected to yield an annual
cash-flow of £10,000 for the next 5 years
• Initial cost of (Live) is £20,000
• Total profit is £30,000
• Calculate the average rate of return.

• Investment (Live) is expected to yield an annual
cash-flow of £10,000 for the next 5 years
• Initial cost of (Live) is £20,000
• Total profit is £30,000
• Annual profit = £30,000/5 = £6,000
• ARR= (6,000/20,000) X 100 = 30%

INTRODUCTION

INTRODUCTION
» Focus on profitability
for shareholders
» Consider all of the
returns
» Allow investment
comparison
» Ignore the timing of
return
» Disregards time value
of money

Net present value (NPV)
INTRODUCTION
Calculates the monetary value today
of the investments future cash-flow
Source: http://www.or-as.be/sites/default/files/images/blog_pics/npv.jpg
HL

• Takes into account the fact that money value
change with time
• Value of money is affected by interest rates,
which are the result of the societal and
political environment
INTRODUCTION
HL

INTRODUCTION
Source: http://www.dicamillocompanion.com/images/British%20Money/One_Pound_Coin_2002.jpg
Source: http://www.back-
werk.de/images/upload/1/cr
oissants/backwerk-
croissant_tb.jpg
Source:
http://www.creationf
ood.ca/wp-
content/uploads/201
5/02/croissants-
korea-AFPrelax-
151113.jpg
2005 2015
HL

INTRODUCTION
The principle:
How much would you need to
invest today to earn x amount in x
years time?
HL

INTRODUCTION
How much would you have to
invest now to earn £100 in one
year’s time if the interest rate was
5%?
HL

INTRODUCTION
How much would you have to
invest now to earn £100 in one
year’s time if the interest rate was
5%?
£95
HL

• Project (Happy) costs £1,000,000
• After 5 years the cash returns is 10% = 100,000
• A bank offered you an interest of 12% if you invested
the £1 million into them.
• Which one would you consider ?
HL

• The time value of money depends on:
– The interest rate: the higher the rate the less value
future cash in today’s money
– Time: the longer in future to receive cash the less value it
has today
INTRODUCTION
HL

• The present value (PV) of money:
INTRODUCTION
i : interest rate
PV =
( 1 + i )
Future value
n
n : number of years
DiscountingCashFlow
HL

• The present value (PV) of money:
INTRODUCTION
PV = Cash-flow X discount factor
HL

INTRODUCTION
Years Discerption Return Cost Net
Return
Discount
Factor @
10%
Present
Value
0 Initial Capital 0 4000 (4000) X 1.00 = -4000
1 Operation 3000 1750 1250 X 0.91 = 1138
2 Operation 4000 2000 200 X 0.83 = 1660
3 Operation 4500 2250 2250 X 0.75 = 1688
4 Operation 4500 2250 2250 X 0.68 = 1530
5 Operation 3000 1750 1250 X 0.62 = 775
NPV + 2791
HL

INTRODUCTION
» Consider both the
timing and size of return
» Flexible to
accommodate the
changes in discount rate
» Consider time value of
money and opportunity
cost
» Complex to calculate
and explain
» Depends on the rate
of discount
» Only compare with
projects that have the
same initial capital cost
HL

Non-numerical factors
• Aims and objectives of the business
• Length of the project
• Size of the investment
• Economic and Societal environment
• Market environment
• Management experience
• Risk level
INTRODUCTION INVESTMENT APPRIASAL QUANTITATIVE TECHNIQUES QUALTITATIVE TECH
HL

Summary
• Explained what investment means in business
• Discussed the importance of investment appraisal
to the business
• Explained the different techniques to apprise an
investment and calculate its payback period,
Average rate of return, and Net value return
• Understand the impact of non-financial factors on
business investment decision
INTRODUCTION INVESTMENT APPRIASAL QUANTITATIVE TECHNIQUES QUALTITATIVE TECH

Investment Apprasial

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