3.7.8 Analysing strategic options: investment appraisal


    3.7.8 Analysing strategic options: investment appraisal

    Financial methods of assessing an investment

    Investment Appraisal = the process of analysing whether investment projects are worthwhile


    Financial methods of assessing investment:

    • Payback
    • Average rate of return
    • Net present value (NPV)


    Reasons why businesses invest:

    • Investment is the process of purchasing non current assets like buildings and machinery
    • Investment considers the buying of an asset that will pay for itself over a period of more than one year
    • It is done to replace and renew assets, and to introduce additional assets


    Payback = the length of time it takes for an investment to recover the initial expenditure (usually measured in months or years)

    • It focuses on cash flow and looks at a cumulative cash flow of the investment up to the point which the original investment has been recouped from the investment cash flow


    Advantages of payback:

    • Simple and easy to calculate, and easy to understand the results
    • Focuses on cash flows – good for use by businesses where cash is a scarce resource
    • Emphasises speed of return; may be appropriate for businesses subject to significant market change
    • Straightforward to compare competing projects


    Disadvantages of payback:

    • Ignores cash flows which arise after the payback has been reached (i.e. does not look at the overall project return)
    • Takes no account of the time value of money
    • May encourage short-term thinking
    • Ignores qualitative aspects of a decision
    • Does not actually create a decision for the investment


    Average Rate of Return (ARR) = the total net returns divided by the expected lifetime of the investment, expressed as a % of the initial cost of investment

    • Business investment projects need to earn a satisfactory rate of return if they are to justify their allocation of scarce capital – the ARR looks at the total accounting return for a project to see if it meets the target return
    • = average rate of return / asset’s initial cost x 100 (average annual profit (AAP) = total net profit before tax over the assets lifetime / life of asset in years)

    Advantages of average rate of return:

    • ARR provides a percentage return which can be compared with a target return
    • ARR looks at the whole profitability of the project
    • Focuses on profitability – a key issue for shareholders


    Disadvantages of average rate of return:

    • Does not take into account cash flows – only profits (they may not be the same thing)
    • Takes no account of the time value of money
    • Treats profits arising late in the project in the same way as those which might arise early


    Net Present Value (NPV) = this compares the amount invested today to the present value of the further cash receipts from the investment

    • It reflects the time value of money by discounting the value of future cash flow
    • When applying the discount factor, divide by 1.(the rate) (e.g. 10% = 1.1 and 5% = 1.05)

    Advantages of net present value:

    • Takes account of time value of money, placing emphasis on earlier cash flows
    • Looks at all the cash flows involved through the life of the project
    • Use of discounting reduces the impact of long-term, less likely cash flows
    • Has a decision-making mechanism – reject projects with negative NPV


    Disadvantages of net present value:

    • More complicated method – users may find it hard to understand
    • Difficult to select the most appropriate discount rate – may lead to good projects being rejected
    • The NPV calculation is very sensitive to the initial investment cost


    Factors influencing investment decisions

    Characteristics of capital investment decisions:

    • Involves long terms commitment of capital sums
    • Benefits are received as a stream stretching long into the future
    • They are almost impossible to reverse without accepting a significant loss
    • Contain an element of uncertainty
    • Costs are incurred today but benefit in the future
    • They affect future probability and the firms very existence


    Factors that affect investment decisions:

    • Interest rates (the cost of borrowing)
    • Economic growth (changes in demand)
    • Confidence/expectations
    • Technological developments (productivity in capital)
    • Availability of finance from banks
    • Others such as depreciation, wage costs, inflation, and government policy


    The value of sensitivity analysis

    What sensitivity analysis includes:

    • Allows key assumptions to be changed to analyse the effect
    • Helps judge the degree of risk
    • Recognises there is no such thing as an accurate forecast
    • Considers one variable/assumption at a time


    Advantages of sensitivity analysis:

    • Helps assess risks and prepare for a less than favourable scenario
    • Identifies the most significant assumptions (which therefore enquire closer attention)
    • Helps make the process of business forecasting more robust


    Disadvantages of sensitivity analysis:

    • Only tests one assumption at a time
    • Only as good as the data which the forecast is based upon
    • Complicated concept


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