3.8: Investment Appraisal

What Is Investment Appraisal?

Quantitative Investment Appraisal

Qualitative Investment Appraisal

investment: purchasing capital goods & improving existing fixed assets

investment appraisal: evaluating the profitability or desirability of an investment project

undertaken by using quantitative techniques

non-financial issues are also significant, and therefore qualitative appraisal

there is also ‘intuitive’ or ‘hunch’ methods of taking investment decisions

information required:

initial capital cost of investment (with installation cost)

estimated life expectancy

residual value of the investment

forecasted net returns or net cash flows from the project

Payback Period

Average Rate of Return

Discounting Future Cash Flows

Forecasting Cash Flows in Uncertain Environment

annual forecasted net cash flow: forecasted cash inflow minus forecasted cash outflows

assume that cash inflows = annual revenues earned from the project & the cash outflows = annual operating costs

not easy & rarely 100% accurate

external factors can affect long term cash flow forecasts

all investment decisions involve some risk due to uncertainty

payback period: length of time it takes for the net cash inflows to pay back the original capital cost of the investment

AAR = [annual profit (net cash flow) / initial capital cost] * 100

when the other methods give conflicting results

can be compared with the payback on alternative investments

‘year 0’ = time period in which the investment is made

cash flow at this time is negative

becomes less and less negative as further cash inflows are received

(additional cash inflow needed / annual cash flow in year X) * 12 months

used as a quick check on the viability of a project or as a means of comparing projects

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average rate of return (ARR): measures the annual profitability of an investment as a percentage of the initial investment

assume that the net cash flows = annual profitability

4⃣ stages

  1. add all positive cash flows
  1. subtract cost of investment
  1. divide by lifespan
  1. calculate the annual profit as % of the initial cost

can be compared with:

other proyects

citerion rate: minimum level (maximum for payback period) set by management for investment appraisal results for a project to be accepted

the annual interest rate on loans

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Net Present Value (NPV)

solves problem of trying to compare projects with different returns and payback periods

considers both the size of cash flows and the timing of them

takes the ‘time value of money’ into consideration

discounting: the process of reducing the value of future cash flows to give them their value in today’s terms

depends on the rate of interest

2⃣ factors

  1. The higher the interest rate, the less value future cash has in today’s money.
  1. The longer into the future cash is received, the less value it has today.

multiply the appropriate discount factor by the cash flow

uses discounted cash flows

total discounted cash flows - capital cost of the investment

3⃣ stages

  1. Multiply discount factors by the cash flows (cash flows in year 0 are never discounted)

net present value: today’s value of the estimated cash flows resulting from an investment

  1. Add the discounted cash flows
  1. Subtract the capital cost to give the NPV

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the impact on the environment and the local community

planning permission

aims and objectives of the business

risk

Cecilia Martínez A01197738

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