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A LevelBusinessAQARevision Notes7. Analysing the Strategic Position of a Business (A Level)7.5 Investment AppraisalInvestment Appraisal Methods

Investment Appraisal Methods (AQA A Level Business): Revision Note

Exam code: 7132

Lisa Eades

Written by: Lisa Eades

Reviewed by: Steve Vorster

Updated on

An introduction to investment appraisal

  • Investment appraisal involves comparing the expected future cash flows of an investment with the initial outlay for that investment

  • A business may want to analyse 

    • How soon the investment will recoup the initial outlay

    • How profitable the investment will be

  • Before an investment can be appraised, key data will need to be collected, including

    • Sales forecasts

    • Fixed and variable costs data

    • Pricing information

    • Borrowing costs

  • The collection and analysis of this data is likely to take some time

    • It requires significant experience to interpret the data appropriately before the investment appraisal can take place

  • Different methods are used to appraise the value of an investment, including:

    • The simple payback period

    • The average rate of return (ARR)

    • The net present value of discounted cash flow

Payback

  • The payback period is a calculation of the amount of time it is expected an investment will take to pay for itself

  • Where net cash flows are expected to be constant over time, the payback period can be calculated using the formula

Payback space period space equals space fraction numerator Initial space outlay over denominator Net space cash space flow space per space period end fraction space equals space Years divided by months

Worked Example

Gomez Carpets is considering an investment in a new storage facility at a cost of £200,000. It expects additional net cash flow of £30,000 per year as a result of the investment.

Calculate the payback period for the investment.

[3]

Step 1 - Divide the initial outlay by the additional expected net cash flow

   equals space fraction numerator £ 200 comma 000 over denominator £ 30 comma 000 end fraction space space equals space 6.67 space years space space (1)

Step 2 - Convert the outcome to years and months

  •  6 years

  • 0.67 years     =    8.04 months  (1)

  • Payback period    =    6 years and 8 months (1)

Worked Example

Hammer and Son provides a household repairs service that has recently employed a new handywoman who requires her own van. The new van will be purchased for £32,000

The net cash flows are expected to vary over the five years following its purchase and are shown in the table below.

Year

Net cash Flow (£)

Cumulative Cash Flow (£)

0

(32,000)

(32,000)

1

14,000

(18,000)

2

10,000

(8,000)

3

6,000

(2,000)

4

3,000

1,000

5

2,000

3,000

 Calculate the payback period for the van.

[4]

Step 1 - Identify the final year where the cumulative cash flow is negative

  •    In this case the cumulative cash flow figure is  -£2,000 at the end of Year 3

  •    This is the remaining amount (outlay) outstanding. (1)

Step 2 - Calculate the monthly net cash flow for the next year

equals space £ 3 comma 000 space divided by space 12 space left parenthesis months right parenthesis space equals space £ 250  (1)

Step 3 - Divide the remaining outlay outstanding by the monthly net cash flow

equals space £ 2000 space divided by space £ 250 equals space 8 space months  (1)

Step 4 - Identify the payback period

  • In this case the Payback period is 3 years and 8 months   (1)

Evaluation of the payback period method

Benefits

Drawbacks

  • It is a simple method to calculate and understand

  • It is particularly useful for businesses where cash flow management is vital

  • Businesses can identify the point at which an investment is paid back and contributing positively to cash flow

  • It is also useful where new technology is introduced regularly

  • Businesses purchasing equipment can calculate whether an investment ‘pays back’ before an upgrade is available

  • It provides no insight into the profitability of investments

  • Payback only considers the total length of time to recover an investment

  • Neither the timing nor the future value of cash inflows is considered

  • It may encourage a short-termism approach

  • Potentially lucrative investments may be dismissed as they take longer to pay back than alternatives

Average rate of return (ARR)

  • The average rate of return compares the average  profit per year generated by an investment with the value of the initial outlay

  • The average rate of return is calculated using the formula

ARR space equals space fraction numerator Average space annual space return over denominator Initial space outlay end fraction space space space space space space space cross times space space space space space space space space space 100 space space space space space space

  • The outcome of the formula is expressed as a percentage, which makes it easy to compare different investment options

Worked Example

Creative Frames, a small artwork framing business, is considering an investment of £40,000 in new machinery. Megan, the business owner, believes that total cash inflows over a 6-year period will be £140,000 and total cash outflows will be £92,000.

Calculate the average rate of return of the proposed investment. 

[4]

Step 1 - Calculate the total profit over the lifetime of the investment

space Total space cash space inflows space space minus space Total space cash space outflows space equals space Total space profit equals space £ 140 comma 000 space minus space £ 92 comma 000 space equals space £ 48 comma 000  (1)

Step 2 - Divide the total profit by the number of years of the investment project to find the average annual profit

equals space £ 48 comma 000 space divided by space 6 space years space equals space £ 8 comma 000 space space  (1)

Step 3 - Divide the average annual profit by the initial outlay

equals space £ 8 comma 000 space divided by space £ 40 comma 000 equals space space 0.2 space space space space space  (1)

 
Step 4 - Multiply the outcome by 100 to find the percentage

equals space 0.2 space cross times space 100 equals space 20 percent sign space (1)

Evaluation of the average rate of return (ARR)

Benefits

Drawbacks

  • It considers all of the net cash flows generated by an investment over time

  • It is easy to understand and compare the percentage returns with each other

  • As it depends on an average of cash flows, it ignores the timing of those cash flows

  • The opportunity cost of the investment is ignored as values are nether expressed in real terms nor adjustments made for the impact of interest rates and time

Net present value (NPV)

  • Net Present Value (NPV) evaluates the value of an investment or a project

  • It takes into account the effects of interest rates and time

    • It represents the present value of the future cash inflows minus the present value of the future cash outflows

    • To get the present value, the future value has to be discounted (reduced)

  • This discounting method recognises

    • That money received in the future is worth less than money received today due to inflation

    • The opportunity cost of not having the money available for other uses

  • To calculate the Net Present Value of an investment, the value of all future net cash flows in today’s terms need to be calculated first - and then discounted using a table

    • The cost of the initial investment is deducted from the total of the discounted net cash flows

      • If future net cash flows minus the initial investment is positive, then the investment is likely to be worthwhile

      • If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile

  • Discounted cash flows are calculated using discount tables which allow future cash flows to be expressed in today’s terms

Worked Example

Brownsea Sightseeing Tours Ltd is considering purchasing a new pleasure craft at a cost of £325,000.  It expects the investment to achieve the following net cash flows over five years of operation

Year

Net cash Flow (£)

10% Discount Factor

0

(325,000)

1.00

1

110,000

0.91

2

90,000

0.83

3

75,000

0.75

4

65,000

0.68

5

60,000

0.62

Using the 10% discount factor, calculate the NPV of the leisure craft investment.

[4]

Step 1 - Calculate the discounted cash flow for each year by multiplying the net cash flow by the discount factor

Table showing net cash flow, 10% discount factor, and discounted cash flow from year 0 to 5, with calculations highlighted on the right.

(2)

Step 2 - Add together the discounted cash flow values for each year, including Year 0   

equals space £ 325 comma 000 space plus space £ 100 comma 100 space plus space £ 74 comma 400 space £ 56 comma 250 space plus space £ 44 comma 200 space plus space £ 37 comma 200 equals space left parenthesis 12 comma 550 right parenthesis (1)

  • The net present value of the investment is -£12,550

  • This suggests that the investment in the new pleasure craft is not financially worthwhile (1)

Evaluation of the net present value method

Benefits

Drawbacks

  • It considers the opportunity cost of money

  • Discount tables are used to calculate forecast future values of net cashflows

  • Businesses may choose different discount tables (20%, 10%, 5% etc)  to adjust the level of risk involved in a project, allowing a range of scenarios to be considered

  • It is more complicated to calculate and interpret than other methods of investment appraisal

  • Accurately forecasting future cash flows can be difficult

  • Selecting an appropriate discount rate can be challenging as even small changes in the discount rate can impact the calculated NPV

  • The NPV method only considers the financial costs and benefits of a project

Examiner Tips and Tricks

With ARR or NPV, always compare options clearly and explain what the results mean for a business – don’t just state the numbers

Limitations of investment appraisal

  • Each techniques relies upon forecasted future cash flows, which may lack accuracy

    • Managers may lack experience or may be biased towards a particular investment

    • Incomplete past data may make forecasting imprecise or mean that confidence in the data is limited

  • Longer-term forecasts used to predict returns on investments may be inaccurate for a variety of reasons

    • Unexpected increases in costs

    • The arrival of new competitors

    • Changes in consumer tastes

    • Uncertainties arising as a result of economic growth or recession

  • Non-financial factors are ignored

    • Business finances and availability of external finance to fund the investment

    • Overall corporate objectives 

    • Potential for positive public relations or meeting social responsibilities

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    Author
    Reviewer
    Lisa Eades

    Author: Lisa Eades

    Expertise: Business Content Creator

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.

    Steve Vorster

    Reviewer: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.