Finance theory

Investment appraisal

One of the most important long-term decisions for any business relates to investment. Investment is the purchase or creation of assets with the objective of making gains in the future. Typically investment involves using financial resources to purchase a machine/ building or other asset, which will then yield returns to an organisation over a period of time.

Key considerations in making investment decisions are:

• How much will the investment cost? Are there funds available?
• How long will it be before the investment starts to yield returns?
• How long will it take to pay back the investment?
• What are the expected profits from the investment?
• Could the money that is being ploughed into the investment yield higher returns elsewhere?

A company is considering an investment costing £20m. Its projected returns extend over four years:

Year       Cash inflow      Cash outflow    Cumulative cashflow

0                -                       20                    - 20

1                6                        -                     - 14

2                8                        -                     - 6

3              12                        -                        6

4              10                        -                       16

There are several methods for evaluating the returns on an investment project. The Average Rate of Return (ARR) calculates the average annual return as a percentage of the investment:

• Total outlay   = £20m
• Total returns  = £36m
• Net return      = £16m

Average annual return       = £16m/4yrs = £4m

Average Rate of Return (ARR) = £4m/£20m X 100 = 20%

This percentage rate can be compared with rates for other possible projects and with the relevant rate of interest.

A firm is also concerned with how soon the original outlay for a project will be returned. This is vital to cashflow and a good indicator of risk (cashflows projected to occur sooner carry less risk).

The payback period for a project is the expected length of time needed for cumulative cashflows to cover the original outlay.

In the example, payback occurs during Year 3. At the end of Year 2, cashflows total cash inflows amount to £14m making a cumulative cashflow of -£6m. Year 3 is projected to generate £12m so the remaining £6m should be generated 6/12ths or half way through Year 3. So the payback period is 2.5 years.

The main problem with the techniques described so far is that they fail to account fully for the timing of cash flows. A pound received today compared with a pound to be received in say, 3 years' time not only carries lower risk but can also be re-invested at a positive rate of return. Other investment appraisal techniques take this factor into account and are covered in the theory page on discounted cash flow.

Supporting Documents

These downloads will help to put finance theory into context using real world examples from real businesses.