3. What is investment?
Definitions
Definitions
1. The purchase of capital
1. The purchase of capital
goods
goods
2. Expenditure by a business
2. Expenditure by a business
which is likely to yield a
which is likely to yield a
return in the future
return in the future
4. Capital goods
tools, vehicles,
computers, information
technology, machines
Construction
Spending on new
buildings bought or
constructed
Types of investment
Public sector
investment
About 25% of all
investment, includes
building of schools,
roads, hospitals
Stocks
these include
finished goods and
work in progress
5. To replace
To replace
work out /
work out /
obsolete
obsolete
equipment
equipment
For research
For research
and investment
and investment
Reasons for investment
To grow the
To grow the
business
business
this can be organic
this can be organic
growth or acquisitions
growth or acquisitions
To minimise
To minimise
costs or
costs or
improve quality
improve quality
7. Investment appraisal
Definition
Definition
How a private sector business
How a private sector business
might objectively evaluate an
might objectively evaluate an
investment project to decide:
investment project to decide:
-whether or not it is profitable
-whether or not it is profitable
-make comparisons between
-make comparisons between
different investment projects
different investment projects
8. The basis of investment
appraisal
Compare the capital cost to the net cash flow
Capital cost
amount spent on the investment project
Net cash flow
estimated revenue generated from the project
minus
estimated running costs of the project
9. Payback period
Payback period
the amount of time
the amount of time
it takes for the
it takes for the
project to payback
project to payback
initial outlay
initial outlay
Average rate
Average rate
of return
of return
measures the met
measures the met
return each year as aa
return each year as
percentage of capital
percentage of capital
cost
cost
Methods of appraisal
Net present value
Net present value
what the cash flow or profit earned in
what the cash flow or profit earned in
the future is worth in today’s money
the future is worth in today’s money
10. Estimate net
Estimate net
cash flow
cash flow
Calculate
Calculate
cumulative net
cumulative net
cash flow
cash flow
cash flow in each year
cash flow in each year
adjusted for cost of the
adjusted for cost of the
project
project
Payback period – method 1
Calculate payback period
Calculate payback period
found when cumulative net cash flow is
found when cumulative net cash flow is
zero
zero
11. Task 1
Calculate the cumulative net cash flow and the
payback period from the information given on the
worksheet
12. Find year
Find year
before project
before project
pays back
pays back
Calculate ‘amount
Calculate ‘amount
required’ to
required’ to
payback
payback
equals cumulative cash
equals cumulative cash
flow for that year ==cost
flow for that year cost
of project ––sum of net
of project sum of net
cash flows
cash flows
Payback period – method 2
Add remaining months to
Add remaining months to
year
year
remaining months = amount required /
remaining months = amount required /
net cash flow in year of payback x 12
net cash flow in year of payback x 12
13. Payback - alternative
An alternative ‘formula’ for calculating payback is
Years = last year in which cumulative cash flow is
negative
Months = Last negative cumulative cash flow × 12
Net cash flow in year after
14. Task 2
Calculate cumulative cash flow, total net cash flow
and the payback period for each of the
investment projects on the worksheet
Which investment project would the business
choose using the payback period method of
appraisal?
Can you spot a problem with the payback method
of appraisal?
15. Average rate of return (ARR)
Calculate profit
Calculate profit
from project
from project
==total net cash flow ––
total net cash flow
capital cost
capital cost
Calculate profit
Calculate profit
per annum
per annum
==profit //number of years
profit number of years
project runs for
project runs for
Calculate ARR
Calculate ARR
net return (profit) per annum
ARR =
x 100
Capital outlay (cost)
16. Task 3
Calculate the ARR for the three investment
projects on the worksheet.
Which investment project should the business
choose?
17. Advantages and disadvantages
Advantages
Advantages
allows projects to be compared
allows projects to be compared
clearly shows profitability
clearly shows profitability
can be compared to other uses of funds eg bank
can be compared to other uses of funds eg bank
deposits
deposits
easy to identify opportunity cost
easy to identify opportunity cost
Disadvantages
Disadvantages
does not take into account payback period ––
does not take into account payback period
important where cash flow is an issue
important where cash flow is an issue
does not take account of effect of time on money
does not take account of effect of time on money
eg money received in the future is worth less
eg money received in the future is worth less
than money received today
than money received today
18. Net present value (NPV)
The underlying principle of the NPV technique
is that money received in the future is worth
less that money received today
To understand this idea you should calculate
the compound value of £100 invested over 5
years at a rate of interest of 10%
what is £100 worth in 5 years time?
what is £133 in three year’s time worth
today?
19. Net present value (NPV)
Calculate present
Calculate present
values of annual
values of annual
net cash flows
net cash flows
==discounted net cash
discounted net cash
flows
flows
Sum the
Sum the
present values
present values
(discounted net
(discounted net
cash flows)
cash flows)
Calculate NPV
Calculate NPV
==total present values ––initial cost of investment
total present values initial cost of investment
20. Advantages and disadvantages
Advantages
Advantages
takes account of the value of future earnings
takes account of the value of future earnings
discount rate can be changed to assess different
discount rate can be changed to assess different
risks or changes in financial market conditions
risks or changes in financial market conditions
useful where investments do not generate cash
useful where investments do not generate cash
flows until some time in the future
flows until some time in the future
Disadvantages
Disadvantages
the most complex method of investment appraisal
the most complex method of investment appraisal
unlikely to be used by small businesses
unlikely to be used by small businesses
result is highly dependent on discount rate chosen
result is highly dependent on discount rate chosen
the higher the discount rate, the fewer projects
the higher the discount rate, the fewer projects
are likely to be profitable
are likely to be profitable
