This introductory revision presentation guides students through the concept of basic investment appraisal. It examines the nature of capital investment spending and then outlines three common approaches to investment appraisal: payback period, net present value and accounting rate of return. Some key evaluative points relating to investment appraisal are also discussed.

1. Making
Investment
Decisions

2. Capital v Revenue Expenditure
Capital
Capital Revenue
Revenue
Cash spent on Cash spent on day-to-
investment in the day operations: e.g.
business: e.g.
Raw materials
Plant & machinery Energy costs
Factory buildings Wages and salaries
IT systems Marketing costs
Distribution equipment Office administration
Fixtures and fittings

3. Capital expenditure = long-term
The main distinction is that capital
The main distinction is that capital
expenditure is on non-current
expenditure is on non-current
assets which have an “economic
assets which have an “economic
life” in the business – they are
life” in the business – they are
intended to be kept, rather than
intended to be kept, rather than
sold or turned into products
sold or turned into products

4. Many reasons for capital expenditure
• To add extra production capacity
• To replace worn-out, broken or
obsolete machinery and equipment
• To support the introduction of new
products and production processes
• To implement improved IT systems
• To comply with changing legislation &
regulations

5. The implication of scarce finance
The Problem
The Problem Choices have to be
made
Finance in
Finance in Which investments
nearly every
nearly every justify the risks?
business is
business is How to choose
between competing
scarce
scarce investments?

6. What is investment appraisal?
The process of
analysing whether
investment projects
are worthwhile

7. Three main methods
Payback period
Net present value
Average rate of return

8. An example investment project
An investment of £500,000 is expected to generate the following
An investment of £500,000 is expected to generate the following
revenues, costs and cash flows over the 5 year life of the project
revenues, costs and cash flows over the 5 year life of the project
Year Investment Revenue Costs Profit Cumulative Cash flow Cumulative
Profit Cash Flow
£’000 £’000 £’000 £’000 £’000 £’000 £’000
0 -500 0 0 -0 0 -500 -500
1 0 150 200 -50 -50 -50 -550
2 0 300 200 100 50 100 -450
3 0 400 150 250 300 250 -200
4 0 600 150 450 750 450 250
5 0 700 100 600 1,350 600 850
Total 500 2,150 800 1,350 850

9. Payback period
The payback period is
the time it takes for a
project to repay its
initial investment

10. Where does payback occur?
Payback for the project arises
Payback for the project arises
£200,000/£450,000 through Year 4
£200,000/£450,000 through Year 4
= approx 23 weeks through Year 4
= approx 23 weeks through Year 4
So the payback period = 3 years + 23 weeks
So the payback period = 3 years + 23 weeks

11. Benefits and drawbacks of payback
Advantages Disadvantages
Simple and easy to calculate + easy Ignores cash flows which arise after the
to understand the results payback has been reached – i.e. does
not look at the overall project return
Focuses on cash – which is Takes no account of the “time value of
normally scarce money”
Emphasises speed of return; good May encourage short-term thinking
for markets which change rapidly
Straightforward to compare Ignores qualitative aspects of a decision
competing projects
Does not actually create a decision for
the investment

12. Net present value
Net present value
Net present value
(“NPV”) calculates the
(“NPV”) calculates the
monetary value now of
monetary value now of
the project’s future cash
the future cash
flows
flows

13. The importance of time
? Would you rather have?
Would you rather have?
£100 or £100
Now
Now In 12 months
In 12 months

14. The time value of money
• Better to receive cash now rather
than in the future
• Future cash flows are “worth less”
• Use discount factors to bring cash
flows back to their “present value”
• Relevant discount factor determined
by required rate of return

15. NPV of the project
NPV of the project is positive (£405k),
NPV of the project is positive (£405k),
suggesting the investment is worthwhile
suggesting the investment is worthwhile
using a 10% discount rate
using a 10% discount rate

16. Benefits and drawbacks of NPV
Advantages Disadvantages
Takes account of time value of More complicated method – users
money, placing emphasis on earlier may find it hard to understand
cash flows
Looks at all the cash flows involved Difficult to select the most
through the life of the project appropriate discount rate – may
lead to good projects being
rejected
Use of discounting reduces the The NPV calculation is very
impact of long-term, less likely cash sensitive to the initial investment
flows cost
Has a decision-making mechanism
– reject projects with negative NPV

17. Average rate of return (“ARR”)
The average rate of return
The average rate of return
(“ARR”) method looks at
(“ARR”) method looks at
the total accounting return
the total accounting return
for a project to see if it
for a project to see if it
meets the target return
meets the target return

18. Calculating ARR
Total net profit / No years
ARR (%) = x 100
Initial cost
Example Project
Example Project
Total net profit (5 years) = £1,350,000
Total net profit (5 years) = £1,350,000
Divided by project life = £1,350,000 //5
Divided by project life = £1,350,000 5
= £270,000
= £270,000
Divided by the initial cost (£500,000) = £270,000 //
Divided by the initial cost (£500,000) = £270,000
£500,000 = 54%
£500,000 = 54%

19. Benefits and drawbacks of ARR
Advantages Disadvantages
ARR provides a percentage Does not take into account
return which can be cash flows – only profits (they
compared with a target return may not be the same thing)
ARR looks at the whole Takes no account of the time
profitability of the project value of money
Focuses on profitability – a Treats profits arising late in
key issue for shareholders the project in the same way as
those which might arise early

20. Risks and uncertainties in investment
appraisal
Risk Issue
Length of the The longer the project, the greater the risk that estimated revenues,
project costs and cash flows prove unrealistic
Source of the Are estimated project profits and cash flows based on detailed
data research, gut feel, or a little of both?
Size of the An investment that uses most of the available business funds is, by
investment definition, more risky than a smaller project. Risk is also about the
consequences to the business if something goes wrong!
Economic and A major issue for most large investments. Most projects will make
market assumptions about demand, costs, pricing etc which can become
environment wildly inaccurate through changing market and economic conditions
Experiencec of A project in a market in which the management team has strong
management experience is a lower-risk proposition than one in which the business
team is taking a step into the unknown!

21. Qualitative factors to consider
• The impact on employees
• Product quality and customer service
• Consistency of the investment decision with
corporate objectives
• The business’ brand and image, including
reputation
• Implications for operations, including any
disruption or change to the existing set-up
• Responsibilities to society and other
external stakeholders

22. Setting the investment criteria
• Payback, NPV and ARR can create
conflicting results – how to decide?
• Possible criteria might suggest only
accepting investment proposals which
meet at least two measures
• E.g.
– A payback within four years
– ARR of at least 20%, with no profits taken into
account beyond Year 5
– NPV of at least 25% of the initial investment

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