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A LevelBusinessCambridge (CIE)Revision Notes5. Finance & AccountingInvestment Appraisal (A Level)Methods of Investment Appraisal

Methods of Investment Appraisal (Cambridge (CIE) A Level Business): Revision Note

Exam code: 9609

Lisa Eades

Written by: Lisa Eades

Reviewed by: Steve Vorster

Updated on

The need for investment appraisal

  • Investment appraisal involves comparing the expected future cash flows of an investment with the initial expenditure on 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  

Payback period

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

  • The payback period is 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 space space equals space space 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: Substitute the values into the formula

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

Step 2: Convert the outcome to years and months

6 space years space space 0.67 space years space equals space 8.04 space months Payback space period space equals space 6 space years space and space 8 space months (1)

Evaluating the use of the payback method

Advantages

Disadvantages

  • 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 contribute positively to cash flow

  • It is also useful when 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

  • This method 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

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

  • The average rate of return is calculated using the formula and is expressed as a percentage

    • This makes it easy to compare different investment options

ARR space equals space fraction numerator open parentheses Total space returns space minus space Capital space cost close parentheses space divided by space Years space of space use over denominator Capital space cost end fraction space space space cross times space space 100 space space space space space space

Worked Example

Creative Frames, a small artwork framing business based in Bermuda, is considering an investment of $40,000 in new machinery. Megan, the business owner, believes that total returns over a 6-year period will be $76,000

Calculate the average rate of return of the proposed investment. 

(4)

Step 1 - Deduct the capital cost from the total returns

equals space $ 76 comma 000 space minus space $ 40 comma 000 space space space equals space space space $ 36 comma 000 space (1)


Step 2 - Divide the outcome by the number of years of use

equals space $ 36 comma 000 space divided by space 6 space years equals space space space space space space $ 6 comma 000   (1)
 

Step 3 - Substitute the values into the formula

equals space fraction numerator 6 comma 000 over denominator 40 comma 000 end fraction space straight x space 100 equals space 0.15 (1)

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

 equals space 0.15 space cross times space 100 space equals space 15 percent sign (1)

Evaluating the use of average rate of return

Advantages

Disadvantages

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

  • ARR 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 neither expressed in real terms nor adjusted for the impact of interest rates and time

The meaning of net present value

  • The net present value (NPV) takes into account the effects of interest rates and time

  • It recognises

    • The fact that that money received in the future is often worth less than money received today (inflation)

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

Calculation of net present value

  • To calculate the NPV 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 are 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

Discount factors at different rates of interest

Table of interest rates for years 1 to 10, with columns for rates ranging from 1% to 10%, framed with a blue border.
Discount factors at different levels of interest

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 (2dp)

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 a 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

3-3-2-net-present-value-of-discounted-cash-flow

(3)

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

open parentheses £ 325 comma 000 close parentheses 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

Interpretation of net present value

  • The outcome of the NPV calculation often determines the decision a business makes about an investment

Net present value outcomes

NPV result

Interpretation

Positive

  • The project is expected to earn more than it costs

  • It should be accepted unless qualitative factors suggest otherwise

Zero

  • The project breaks even, meaning future returns equal the cost of the investment

  • The investment decision may depend on other factors

Negative

  • The project is expected to make a loss

  • It should usually be rejected unless qualitative factors suggest otherwise

  • However, care should be taken when assessing NPV outcomes

    • The discount rate matters

      • Choosing a higher rate makes future cash inflows seem smaller

    • NPV uses estimated figures

      • These forecasts may not be accurate

Case Study

Logo of SoluTech Energy featuring a sun with a plug in the centre, symbolising renewable energy. The text "SoluTech Energy" is in dark green.

SoluTech Energy is a medium-sized renewable energy company based in Indonesia. The business is focused on providing sustainable power solutions to rural communities and small businesses

The management team is considering a new investment: installing a set of high-efficiency solar panels at one of their key partner sites. The goal is to reduce long-term energy costs and demonstrate the company’s commitment to clean energy

  • The initial investment required is $50,000

  • After forecasting cash inflows and applying a suitable discount rate (to account for risk and time value of money), SoluTech estimates that the project will generate $60,000 in present value terms over the next few years

Net present value calculation

NPV space equals space $ 60 comma 000 space – space $ 50 comma 000 space equals space $ 10 comma 000

Business decision

  • Since the NPV is positive, SoluTech concludes that the investment will add value to the business

  • The project is expected to generate a return above its cost, so the company decides to go ahead with the investment

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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.