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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