Page 3: Investment appraisal
A business needs to assess if an investment is worth doing - will it recover its costs, will it make savings, will it provide a profit on the original investment? There are several methods of analysing an investment.
The simplest test to understand if an investment will pay for itself is to calculate its payback period. This is the time it will take for the original investment to pay for itself through savings.
The largest cost of most projects occurs at set-up. From the cash flow examples, at the end of year 3, the wind turbines project has a cumulative negative cash flow of £1.9 million. This means that the savings made are still paying back the original costs. It needs £1.9 million more to reach break-even. The project will break even during year 4. The wastewater lagoon needs £0.14 million more at the end of year 4 and will break even in year 5.
McCain can calculate exactly how long it will take to achieve the additional £1.9 million and £0.14 million for the projects.
- McCain can predict payback for the wind turbines in just under three years and eight months.
- The lagoon shows payback in just under four years and one month.
Payback is a simple measure it does help to assess risk but does not consider the value of cash flows after the payback period. Financial forecasts are more uncertain the further they are projected into the future.
Average rate of return
McCain also looks for any investment not just to pay for itself but also to contribute to its profitability. One method of calculating this is the average rate of return (ARR). This shows the expected average return over the life of the project as a percentage of the original investment.
The ARR values help McCain to decide if the projects will give sufficient return.
The wind turbines give a net return of £4.3 million and the lagoon £1.66 million over the assumed project life of five years. The ARR is calculated as:
If McCain needed to choose one project only, the higher percentage return would be better.