Financial planning – the use of quantitative indicators to make a business decisions

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9.3 Financial Planning – the use of

quantitative indicators to make a business decisions

9.3.1 Decision Trees

9.3.2 Investment Appraisal

9.3.3 Break-even (n.b this is not covered

in this presentation)

9.3.2 Investment Appraisal

• A means of assessing whether an

investment project is worthwhile or

not

• Investment project could be the

purchase of a new PC for a small firm, a new piece of equipment in a

manufacturing plant, a whole new

factory, etc

• Used in both public and private sector

Investment Appraisal

investment appraisal:

What factors need to be considered before

investing in equipment such as this?

Copyright: Gergely Erno, stock.xchng

Investment Appraisal

– Importance of remembering investment as the

purchase of productive capacity NOT buying stocks

and shares or investing in a bank!

to:

– Increase capacity (amount that can be produced)

which means:

• Demand can be met and this generates sales revenue

• Increased efficiency and productivity

Investment Appraisal

assumes that the investment will yield future income

A fork lift may be an important item but what

does it contribute to overall sales? How long

and how much work would it have to do to

repay its initial cost?

Copyright: Loisjune, stock.xchng

Method 1 Payback Period

Payback Method

the initial capital cost

• Requires information on the revenue

the investment generates

• e.g A machine costs £600,000

• It produces items that sell at £5 each

and produces 60,000 units per year

• What will the Payback period be ?

This method assumes that the cash inflow will be constant every year

= 2 (years)

Can take account of this investment

by reducing the cash inflows from

the investment over a number of

years

Payback Method with uneven cash

Year 1 £50,000 Year 2 £70,000 Year 3 £100,000 Year 4 £130,000 Year 5 £200,000

Payback Method with uneven cash

Year 1 £50,000 (400,000) Year 2 £70,000 (330,000) Year 3 £100,000 (230,000) Year 4 £130,000 (100,000) Year 5 £200,000 100,000

Method 2 Accounting Rate of Return

(aka Average Rate of Return)

Accounting Rate of Return

generated by the investment with

the cost of the investment

Average annual return or annual profit

• ARR = - x 100

Initial cost of investment or Capital Outlay

Accounting Rate of Return

of £10,000 annually for the next 5 years

(5x£10,000)-£20,000

= £6,000ARR = 6,000/20,000 x 100

= 30%

A worthwhile return?

Activity on ARR

• Clinton Construction is considering 2 projects Using the ARR approach decide which is the better investment.

Project A Project B Initial investment -£10,000 -£20,000

Year 1 cash receipt £4,000 £9,000

Year 2 cash receipt £5,000 £9,000

Year 3 cash receipt £5,000 £12,000

Year 4 cash receipt £4,000 £10,000

Total cash receipt (1)

Profit over 4 years (2)

Average annual profit (3)

Accounting Rate of

Return (4)

Space for calculations

Activity on Accounting Rate of Return

• Clinton Construction is considering 2 projects Using the ARR approach decide which is the better investment.

Project A Project B Initial investment -£10,000 -£20,000

Year 1 cash receipt £4,000 £9,000

Year 2 cash receipt £5,000 £9,000

Year 3 cash receipt £5,000 £12,000

Year 4 cash receipt £4,000 £10,000

Total cash receipt £18,000 £40,000

Profit over 4 years £8,000 £20,000

Average annual profit

Investment Appraisal

• Key considerations for firms in

considering use:

measured accurately

movements can be factored in and

predicted

Investment Appraisal

informed decision, more sophisticated techniques need to

Net Present Value (NPV)

Net Present Value

change with time

consideration

earned if it was investment in something else

Net Present Value

• Project A costs £1,000,000

• After 5 years the cash returns =

£100,000 (10%)

• If you had invested the £1 million into a

bank offering interest at 12% the

returns would be greater

• You might be better off re-considering

your investment!

Net Present Value

• The principle:

• How much would you have to invest now to earn £100

in one year’s time if the interest rate was 5%?

• The amount invested would need to be: £95.24

• Allows comparison of an investment by valuing cash

payments on the project and cash receipts expected to

be earned over the lifetime of the investment at the

same point in time, i.e the present.

• Process referred to as:

‘Discounting Cash Flow’

Net Present Value

NPV =Cash flow x discount factor

rate of interest of 4.25%

= 500 x 0.6595 = £329.77

invest today at a rate of interest of 4.25% to earn £500 in 10 years time

The discount factor can be found through valuation tables (e.g Parry’s Valuation Tables)

Discount

factor is

looked up

in a table

Discounted Cash Flow

• An example:

• A firm is deciding on investing in an

energy efficiency system Two possible

systems are under investigation

• Both cost £600,000 and they both have

the same cash flow after 6 years

However, one yields quicker results in

terms of energy savings than the other

but the second may be more efficient

later on.

• Which should the firm invest in?

Net Present Value (NVP) – System A

Year Cash Flow (£) Discount Factor

(4.75%)

Present Value

(£) (CF x DF)

Net Present Value (NVP)– System B

Year Cash Flow (£) Discount Factor

Net Present Value (NVP)– System A

Year Cash Flow (£) Discount Factor

(4.75%)

Present Value

(£) (CF x DF)

Net Present Value (NVP) – System B

Year Cash Flow (£) Discount Factor

(4.75%)

Present Value

(£) (CF x DF)

• Link to Biz-Ed question(s)