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Page 4: Projected cash flows

An investment – or capital expenditure – involves a cash outflow in the present that is expected to yield greater cash inflow to the future. To do this, managers need to produce the best available financial estimates of the cash inflows and outflows that would result from the investment.

#### Payback

Table 1 shows estimated cash flow for the Grangemouth expansion project. The simplest method of investment appraisal is to calculate the payback period. This is the length of time it takes for the earnings associated with an investment project to cover the initial outlay. In other words, it is when the cumulative earnings equal the original cost of the investment. This is an application of the break-even principle.

As Table 1 shows, the Grangemouth expansion is expected to achieve payback during Year 2. By the end of Year 2 there would be cumulative earnings of £265m (80 +185), considerably more than the £150m initial outlay. The exact payback period is easily calculated by interpolation. Payback is achieved when £70m is earned during Year 2, as when this is added to the £80m earned in Year 1 cumulative earnings equal £150m. It follows that payback will be achieved in Year 2:

The payback period is thus projected at 1 year, 4.5 months or 16.5 months.

This is a relatively short payback period. It is a useful pointer, but does not reflect the true value of the investment. The figure provides no information about the cash flows *after * payback and gives no indication of overall profitability.

#### Average rate of return

To do this, it is usual to calculate the average rate of return (ARR). This is expressed as a percentage of the sum invested. To calculate the ARR for the Grangemouth expansion project, it is necessary to aggregate all outflows and inflows over the life of the project using the data in Table 1.

This allows the net cash flow to be calculated. This is:

This value can then be divided by the number of years of the project’s projected life to get an annual rate of return:

Finally this average value can be expressed as a percentage of the original investment:

#### Opportunity cost

This is an extremely good rate of return. It is usual to compare this against the opportunity cost. This is the return that could be achieved by investing the £150m in another activity. For example, it might be considered more prudent to keep the money in the bank as cash reserves. However, bank interest rates are rarely more than 10%, far less than the 117% returns expected from this project.

There is one major drawback to an analysis based on annual average rates of returns. Unfortunately, ARR takes no account of the *timing * of cash flows. This matters as returns received sooner are less risky – the financial estimates become less certain over time. They are also worth more, since the profits can be reinvested to earn further returns.