Investment Appraisal
Now we have looked at where we can get money from, we have to work out if it is worth spending it. This is called Investment Appraisal. Often, it is deciding between several possible projects. We cannot do everything we want, and in the same way nor can a business. There is an opportunity cost:- what you have give up to be able to do what you choose to do.
There are several ways to carry out investment appraisal. Each has its own advantages and disadvantages.
Payback Method The most simple. All you do is work out how long it takes for a business to get back the money that it spent on the project in the first place. This is really easy, but it is important to set your work out well, so you don’t make silly mistakes.
A worked example to show you how to do it.
Year / Money ($)0 / Initial investment (what we spent) / (50,000)
1 / Revenue (What we received) / 15,000
2 / 15,000
3 / 15,000
4 / 15,000
5 / 15,000
After 1 year, we have spent $50,000 – 15,000 income from the project = $35,000 left to payback.
After 2 years, we have $35,000 (Left to pay) – $15,000 (income from the project) = $20,000 left to pay
After 3 years we have $20,000 – $15,000 = $5,000 left to pay.
After 4 years we have $5,000 – $15,000 = -$10,000 left to pay.
So the answer is 3 and a bit years!
To work out exactly when we divide the 5000 left to pay by the 15000 we get in year 4, and then * (MULTIPLY) the answer by 12 to put it into months. Or by 52 for weeks etc.
5000 *12 = 4 months
15000
So the answer is 3 years and 4 months.
The shorter the time the better the project is.
Advantages of this method are…
· it is fairly simple to calculate
· It is particularly useful for firms with cash flow problems (They want their money back quickly), or for projects, like ICT, where the stuff may well be out of date really quickly, so it’s important that it pays for itself before that happens.
However, it does have a number of problems.
· Money got in after the payback period is not considered.
· The initial cost is not considered. A project that costs a lot to set up, is just as good as one that is cheap, according to this method.
· We assume money comes in evenly through the year.
Average Rate of Return (ARR) A little more tricky, but all you have to do is learn the formula!
Which is… ALL income from the project – Initial cost = Average annual profit How long it will last
Then, take that and.. Average annual profit * 100%
Initial cost
The bigger the % the better the project is.
So for the project above it would be…
15000+15000+15000+15000+15000-50,000 = 5000
5 years
5000 * 100% = 10%
50000
The answer is 10%
Advantages of the ARR
· It uses all of the money over all of the projects life
· It does take into account the cost of the project.
· % are easy for dim wits to compare
Disadvantages are…
· The further into the future we look, the more uncertain things are.
· Ignores the fact that we may have to wait years to see the bulk of the money (There is no time preference for money).
Many firms will have a ‘benchmark %’ against which all projects are judged.
Net Present Value
Think about your own life for a moment. Would you rather have a $1000 today or $1000 in one year’s time? Almost everyone would prefer the money today! Why? Reasons include, uncertainty over the future (who knows if you will actually get the money in one years time?), inflation makes the money worth less in one year’s time, and you can’t enjoy the benefits for another 12 months. Firms are the same. This is called the time value of money.
Net Present Value (NPV) takes account of this. Money in the future is discounted to take account of the fact that it has less value than today, and the further into the future you go the less it is worth.
A firm will decide how much less money in a year’s time will be worth, for example 10% (This is called the discount rate.). All you have to do is to multiply the income by the right discount rate for that year. The question will supply these. For example…
Year / 0 / 1 / 2 / 3 / 4 / 5Discount rate / 1 / 0.91 / 0.83 / 0.75 / 0.675 / 0.6075
Again using the example above…
Year
/ Income / Discount rate / Present value0 / (50,000) / 1 / (50000)*1= / (50,000)
1 / 15,000 / 0.91 / 15000*0.91= / 13,675
2 / 15,000 / 0.83 / 15000*0.83 = / 12,450
3 / 15,000 / 0.75 / 15000*0.75 = / 11,250
4 / 15,000 / 0.675 / 15000*0.675 = / 10,125
5 / 15,000 / 0.6075 / 15000 * 0.6075 = / 9,113
(As you can see the $15,000 becomes worth less and less the further into the future we go.)
Now, all you have to do is to add up the present values. If the answer is positive the project is worth doing, and the bigger the value the better (Again, size is important!).
So, for our example,
($50,000)+$13,675+$12,450+$11,250+$10,125+$9,113 = $6613
This means the project generates a surplus over the initial investment of $6613. A purely logical person would not mind which they had if they were offered $50,000 today, or $56613 over the life of the project.
Exam time This discounting also applies to any costs that are incurred in the future, they are less important because they take place in the future.
Advantages
· All of the income from a project is considered.
· The time value of money is taken into account
Disadvantages
· More complex to calculate
· Does not take into account differences in the initial investment.
· How do we know what the interest rate will be in the future?
Internal Rate of Return (IRR)
So far so good. Now it gets complex. Like NPV, it makes use of discounted future revenues. The problem with NPV is that it is difficult to compare projects with different amounts invested in them, and this method overcomes that. The only snag is that no one really understands it fully.
Instead of picking a discount rate and then seeing what the NPV is, this method finds the discount that gives a NPV of 0, and then compares it to a rate set by the firm to see if a project is worth doing or not. Unfortunately, the only way to do this is trial and error. Computers have made this much easier, but if you have to do this, you have to keep doing the NPV method with different discount rates until you get one that gives an NPV of 0.
The upside of this is that it means it rarely appears in exams, but you have to know it anyway, just in case.
Things to think about when doing an Investment Appraisal question.
· You are looking into the future, and this is never guaranteed to be 100% accurate. The economy changes, interest rates changes, technology changes, blah blah blah. N.B. The further into the future you look the more uncertain things become.
· Risk is not taken into account. The rewards are seen as being certain.
· As usual with the future, how accurate is our data?
· It does force to use quantitative data, and so think logically, rather than basing a decision on ‘gut feeling’, but there may be a whole range of qualitative factors that are not taken into account.
EXAM TIME. If you are comparing two projects, you should also be ready for a split decision. One will be better on one measure and the other on a different measure. You must then use your judgement.
Decide which method is most important to the firm.
Think about the initial cost, the cheaper option, may mean cash left over for other things.
Which will help the firms image?
Which will fit into their existing product or marketing mix?
Which is most risky?
Any other factor that you can think of that is relevant. You must THINK!
Investment Appraisal