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Profitability Investment Appraisal – 2 Investment evaluation A means of evaluating whether an investment project is feasible or not It can help decide better investment opportunities for companies Quantitative and qualitative engineering An investment project can be the purchase of a new PC for a small business, new teams. in manufacturing plants, new plants, etc. Used in the public and private sectors
It is important to remember that investing is buying productive capacity, not buying stocks and shares or investing in banks! Buy equipment/machinery or build a new factory to: Increase capacity (amount that can be produced) means: Demand can be met and this generates sales revenue Increase efficiency and productivity
Profitability Investment Appraisal
7 Evaluation of the investment Therefore, the investment assumes that the investment will generate a stream of income in the future. Investment evaluation consists of comparing that income stream with the cost of the investment. It is not an exact science! The forklift may be an important item, but how does it contribute to overall sales? How long and how much work is needed to cover start-up costs? Copyright: Loisjune, stock.xchng
Land And Building Development Appraisal — Harvey Norman Architects
9 Payback Method The amount of time it takes to pay the initial cost of capital Requires information on the income generated by the investment Assumes that the income will be distributed evenly throughout the year/month* Simple calculation Shows the level of risk: more repayment is riskier (unexpected events. ? ) Disregarding profitability – ignoring cash flow after repayment Often used simply as an idea selection process * Not always the case, e.g. christmas sales
Machine Cost = £600,000 A Revenue Year 1,245,000 Year 2,265,000 Year 3,320,000 Year 4,400,000 Just by looking at what numbers we have repaid the investment in year 1? B year 2? in year 3? But in what month? C.
Compare the average annual return generated by the investment with the money invested. Potential projects can be compared. Focus on the key factors: PROFIT BUT ignore cash flow!
15 Average Rate of Return Step 1: Calculate the total return over the life of the investment (net cash inflow – investment expenses) Step 2: Divide the return by the years the investment will last Average Annual Return or Annual Return ARR = Investment initial cost X 100
The Valuation Of Asset Management Firms
16 ARR Example Year Net Cash Flow Cumulative Cash Flow (20,000) 1 5,000 2 11,000 3 10,000 4 HH Cakes Ltd is considering investing $20,000 in a new oven. Company policy: Invest only in projects that generate more than 15% per year Should I invest in this equipment?
Year Investment A Investment B (10,000) 1 10,000 3,000 2 6,000 3 ARR 30% Cash flows must be considered, not just ARR.
To make more informed decisions, more sophisticated techniques must be used. The importance of the time value of money
Do you want $100 now or in 5 years? Why? Future cash flows are at risk Opportunity cost: what can you do with the money now? We need to know: How much we are looking for next year What the interest rate will be
Capital Investment Model
23 Discount Factor Formula Use – DISCOUNT FACTOR table created for you to use (see page 188 Marcouse) Higher rate if there is interest, and more time before you receive money = less money you have today! ! It can be based on interest rates on: Current rates Expected rates in the next few years Company’s own criteria, e.g. you want all investments to return at least 15% Used in NPV and IRR
1 Discount factor = (1 + i)n Where i = interest rate n = number of years PV of 10% in 1 year is If you invest p today and the interest rate is 10%, you will have £1 in one year . The time process is called: ‘Discount Cash Flow’
Take into account the fact that the value of money changes over time. How much do you need to invest today to get x amount in x years? The value of money is affected by interest rates. Shows what your investment in alternative investment regimes will achieve Allows comparison in REAL terms Only worth the investment if NPV is positive Not always easy to compare if initial investment values are different
Discount factor Present value (A) Cash flow (B) Present value (B) (250,000) 1.00 1 50,000 0.91 45,000 200,000 2 100,000 0.83 3 0.75 NPV (2050, 08) 83,000 37,500 83,000 150,000 28,500 52,500
Editable Investment Appraisal Techniques Template
How much would you need to invest now to earn £100 in a year if the interest rate is 5%? The amount invested should be: £95.24 Allows comparison of the investment by giving the cash payments on the project and the cash receipts expected to be received over the life of the investment at the same time, ie now.
Annual Cash Flow (£) Discount Factor (4.75%) Present Value (£) (CF x DF) – 600,000 1.00 -600,000 1 +75,000 71,599.04 2 +100,000 91 136 41 3 000 130, 505.61 4 +200, 000 166, 116.92 5 +210, 000 166, 513.39 6 113, 544.75 Total 285, 000 NPV = 139.41
Annual Cash Flow (£) Discount Factor (4.75%) Present Value (£) (CF x DF) – 600,000 1.00 -600,000 1 +25,000 23,866.35 2 +75,000 68,352, 31 3 + 000 73,953.18 4 +100,000 83,058.46 5 +150,000 118,938.10 6 +450,000 340,634.30 Total 285,000.08 GO =
Which system represents a better investment? System A – why? System B produces the same performance after six years, but System A’s performance is faster and more costly to the business than the performance that occurs in the next year even though the performance is higher.
Cambridge A Level Investment Appraisal
The IRR is the interest rate (or discount rate) that makes the net present value equal to zero Helps to measure the value of the investment Allows the company to evaluate whether the investment in machinery, etc. will produce a better return based on internals. return standard Allows comparison of projects with different initial costs Tests cash flows at different discount rates Software or simple graphs allow finding the IRR
100 1 +30 2 +35 3 +40 4 +45 (i = interest rate in percentage) Internal Rate of Return (IRR) where IRR = i, IRR = 17.09% Net Present Value (NPV) Therefore using IRR = i = 17.09 %, Calculation IRR.xls
37 Excel: the way forward! It is very difficult to calculate the IRR manually as trial and error is used (it can take hours!) Use Excel = very easy! Assuming that the cash flows (from year 0 to year 5) are in the range “D3:J3”, use the formula =IRR(D$3:J$3)
43 Profitability Index It allows evaluating the comparison of costs and benefits of different projects and thus allows decision making Profitability Index Net Present Value = Initial Capital Cost
Investment Appraisal What Is “investment”? Investment Appraisal
Investment evaluation The main considerations for companies when considering its use: Ease of use / degree of simplicity required Degree of precision required The extent to which future cash flows can be accurately measured. of inflation
In order for this website to work, we record user data and share it with processors. To use this website, you must agree to our Privacy Policy, including our cookie policy. Use of quantitative analysis to analyze if the capital investment is worth it All about COST OF CAPITAL vs NET CASH FLOW For strategic or medium-term objectives, not for tactical decisions.
Three ways to payback How many years and months before initial cost of payback Average Rate of Return (“ARR”) Average annual profit as a percentage of initial investment. Compared to ROCE Net Present Value (“NPV”) Total return on investment in present money (money received in the future is actually cheaper than money today)
3 Payback Measure how long it will take to recoup the original cost of an investment in a new printing press. Look at the initial investment, then the annual cash in and out, for example with a printing press costing £750,000. Use the information in the first table to complete the second Year (£ ) Cash outflow Cash inflow Net cash flow per year Cumulative cash flow 1 2 3 4 5 Total record of initial investment considered to occur in the year 0 Machine A Initial Cost 750,000 Input: Year 1 180,000 Year 2 220,000 Year 3
Applying Investment Appraisal Techniques To Assess Profitability Of Franchise Purchases As Major Capital Budgeting Expenditures
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