Investment Appraisal (Edexcel A Level Business)

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Written by: Lisa Eades, Business Content Creator

Reviewed by: Steve Vorster, Economics & Business Subject Lead

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

Simple Payback Period

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

$\frac{Initial Outlay}{Net Cash Flow per Period} = Years / Months$

Worked Example

1. Simple Payback Calculation

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

$\frac{£ 200, 000}{£ 30, 000} = 6.67 years$ (1 mark)

Step 2 - Convert the outcome to years and months

6 years

0.67 years = 8.04 months (1 mark)

Payback period = 6 years and 8 months (3 marks for the correct answer)

Worked Example

2. Payback calculation for varying cash flow over time

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 mark)

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

£3,000 ÷ 12 (months) = £250 (1 mark)

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

£2000 ÷ £250 = 8 months (1 mark)

Step 4 - Identify the payback period

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

Benefits and Drawbacks of the Using the Payback Method

Benefits	Drawbacks
It is a simple method to calculate and understand It is particularly useful for businesses where the 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

Benefits

Drawbacks

It is a simple method to calculate and understand
It is particularly useful for businesses where the 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

$\frac{average annual return}{initial outlay} \times 100$

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 marks)

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

Total cash inflows - Total cash outflows = Total profit

£140,000 - £92,000 = £48,000 (1 mark)

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

£48,000 ÷ 6 year = £8,000 (1 mark)

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

£8,000 ÷ £40,000 = 0.2 (1 mark)

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

0.2 x 100 = 20% (1 mark)

The Advantages & Disadvantages of Using the Average Rate of Return (ARR)

Advantages	Disadvantages
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 of Discounted Cash Flow

Net Present Value (NPV) is a financial metric used to evaluate the value of an investment or a project
The NPV of an investment 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 takes into account the:
- The fact that 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 marks)

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 marks)

Step 2 - Add together the discounted cash flow values for each year, including Year 0 £325,000 + £100,100 + £74,400 £56,250 + £44,200 + £37,200
= (12,550)

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 mark)

Advantages and Disadvantages of the Net Present Value Method

Advantages	Disadvantages
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 One of the primary challenges of using the NPV method is accurately forecasting future cash flows Selecting an appropriate discount rate can be challenging, and even small changes in the discount rate can significantly impact the calculated NPV The NPV method only considers the financial costs and benefits of a project and does not account for non-financial benefits or costs, e.g. environmental damage

Advantages

Disadvantages

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
One of the primary challenges of using the NPV method is accurately forecasting future cash flows
Selecting an appropriate discount rate can be challenging, and even small changes in the discount rate can significantly impact the calculated NPV
The NPV method only considers the financial costs and benefits of a project and does not account for non-financial benefits or costs, e.g. environmental damage

Examiner Tip

A common error made by students is the assumption that discounted cash flow takes into account the effects of inflation on investment decisions. To account for inflation, the discount rate used in the NPV calculation should be adjusted to reflect the expected inflation rate.

Limitations of Investment Appraisal Techniques

Each of the investment appraisal techniques relies upon forecasted future cash flows which may lack accuracy
- Managers compiling cash flow forecasts 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 used to compile the forecast is limited
Long-term cash flow forecasts can be inaccurate for several reasons
- Unexpected increases in costs
- The arrival of new competitors
- Changes in consumer tastes
- Uncertainties due to economic growth or recession
Factors other than the cost of investment and the return on investment are not considered
- Business finances and availability of external finance to fund the investment
- The overall corporate objectives
- Potential for positive public relations or meeting social responsibilities

Last updated: 25 October 2024

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Investment Appraisal (Edexcel A Level Business)

Revision Note

An Introduction to Investment Appraisal

Simple Payback Period

Worked Example

1. Simple Payback Calculation

Worked Example

2. Payback calculation for varying cash flow over time

Average Rate of Return (ARR)

Worked Example

Net Present Value of Discounted Cash Flow

Worked Example

Examiner Tip

Limitations of Investment Appraisal Techniques

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Author: Lisa Eades

Author: Steve Vorster