Management of Business

Topic: Investment Appraisal

What is investment?

Investment is spending on capital goods(for example, machinery and vehicles) to allow

increased production of goods and services in the future. Investment allows a business to
grow and develop by adding to or replacing some of its operating assets.

Investment Objectives

An investment objective is the end that a business seeks to achieve as a result of carrying
out an investment - for example, to replace an existing asset that is based on old-fashioned
technology.

The aim of an investment may be to:

● increase efficiency (for example, using a more modern and productive machine)
● expand capacity (to produce on a larger scale)
● replace existing assets that are no longer economical to use or that are obsolete
technologically
● comply with health and safety regulations

Investment Appraisal

Investment appraisal is a means of assessing financially whether an investment is

worthwhile.

Purposes of Investment Appraisal

There are two main purposes of appraising an investment:

● to identify whether the benefits of the investment outweigh the costs - the greater the
benefits relative to the costs, the more rewarding the investment opportunity.
● to compare alternative investment opportunities - a business can use capital for
many different purposes, so it needs to assess which investments are likely to yield
the ‘best’ returns.

What constitutes the ‘best’ return is open to discussion and will be explored in the next
sections.

The Limitations of appraising an investment

Investments that a business makes involves the outlay of cash in the present for benefits in
the future. This raises a number of issues:
 ● The future is never predictable - estimates of future revenues and costs are likely to
be less accurate the further into the future they go.
● Factors that are beyond a business’s control can affect the project’s success, such
as:
○ changes in government and the law
○ fluctuating economic conditions, such as interest rates and exchange rates
○ changing market conditions, such as competition and consumer trends.
○ In cash terms, benefits in the future are not as valuable as benefits received
today.

The Planning Horizon

This refers to the period over which the benefits and costs of an investment are calculated.

There are three (3) main methods of Investment Appraisal:

● Payback period
● Average rate of return
● Net present value

Payback Period

This is a commonly used investment appraisal technique that assesses the time period
required for an investment project to ‘pay back’ an initial investment. Payback is a useful
method of appraising investments that become dated very quickly.

For example: computers are replaced rapidly by new models, so a business needs to know
how quickly it can pay back an initial investment in technology so that it knows when it can
invest in a new model.

The military often use payback techniques when investing in armoured vehicles and aircraft,
for example, because they want to keep their equipment up to date. The quicker they can
pay back their investment, the better.

Calculating payback

The calculation is based on cash flow and net profit.

The annual cash flows are cumulated (added up) and the payback period is reached when
the cumulative cash flow reaches zero.

NB**** 1 The relevant year is the year in which cash flow becomes positive.

2 The deficit remaining is the deficit that remained at the start of the year.
3 Year 0 is the year in which the investment was made.

The formula for payback is:

years with negative cumulative cash flow + Deficit remaining x 12 months

Cash flow in relevant year

For Example

Year Project cash flow Cumulative Cash

($) Flow ($)

Investment in fixed asset 0 -45,000 -45,000

Net inflows of cash 1 15,000 -30,000

2 25,000 -5,000

3 20,000 15,000

Based on the table above, the payback time will come somewhere in the third year. The
initial investment in the project was $45,000.

The payback period can be calculated as follows:

Payback period = 2 years + 5,000 X12

20,000

= 2 years and 3 months

The payback method is helpful when comparing alternative projects. The project with the
shortest payback period is the best investment proposition, as the shorter time scale
reduces the risk of unforeseen circumstances affecting returns.

Using payback, we can assess two investment possibilities, Project A and project B, each
costing $15,000.

Project A ($) Project B ($)

Initial cost in Year 0 (15,000) (15,000)

Year 1 cash receipts +3000 +1,000

Year 2 cash receipts +3,000 +3,000

Year 3 cash receipts +4,000 +3,000

 Year 4 cash receipts +5,000 +5,000

Year 5 cash receipts +3,000 +9,000

Required

1 Calculate the payback period for the two investment projects. Calculate the
cumulative cash flow before calculating the payback period.

2 State the project that is more attractive.

Advantages of Payback Period

● Simple to calculate
● Easy to understand

Disadvantages of Payback Period

● Takes no account of timing of cash flows

● does not consider cash flows after the payback period