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All businesses require capital equipment (fixed assets) such as machinery, premises and vehicles. The purchase of such assets is known as capital investment and is undertaken for the following reasons:
To replace existing equipment which is out-of-date or obsolete
To expand the productive capacity of the business
To reduce the production costs per unit (i.e. to achieve economies of scale)
To produce new products and, therefore, break into new markets
Capital investment, like all other business activities, involves an element of uncertainty, because expenditure is incurred today in order to produce some benefit in the future. Investment appraisal techniques are designed to aid decision-making regarding such investment projects.
There are 3 methods which can be used to appraise any investment project:
The Payback method
The Average Rate of Return (A.R.R) method
The Net Present Value (N.P.V) method.
This is the simplest method of investment appraisal and is usually preferred by small businesses because of its simplicity. Larger businesses may use it as a screening process before embarking on one of the more complicated techniques.
The payback period is the time taken for the equipment, (machinery etc.), to generate sufficient net cash flow to pay for itself.
A manufacturing firm is considering investing £ 500,000 in new machinery. The equipment is expected increase the firm's cashflow by £ 150,000 per year. How long is the payback period ?
After 1 year, the cashflow will be £ 150,000.
After 2 years, the cashflow will be £ 300,000.
After 3 years, the cashflow will be £ 450,000.
The firm will need £ 50,000 (or one third) of the cashflow from year 4 in order to reach the payback point.
Therefore, the payback period is 3 1/3 years (or 3 years, 4 months).
Firms can use this technique in one of two ways:
Firstly, a firm could set an upper limit on the time allowed for payback, and any project which is not expected to payback within this period is rejected.
Secondly, when faced with a choice of projects, the payback method can be used to rank projects according to the speed at which they payback.
However, the payback method ignores the following two important factors:
The total return on the investment project (i.e. the earnings after payback).
The timing of the return prior to payback.
The payback method clearly discriminates against projects which produce a slow but substantial return, resulting in the danger that highly profitable projects will be rejected because of the delay in producing a return (yield).
Each of the three alternative projects below involve an initial cost of £ 1 million, and produce net cash flow as shown:
|PROJECT||YEAR 1||YEAR 2||YEAR 3||YEAR 4||YEAR 5|
|A||£ 0m||£ 0.5m||£ 0.5m||£ 0.5m||£ 0.5m|
|B||£ 0.5m||£ 0.5m||£ 0.5m||£ 0m||£ 0m|
|C||£ 0m||£ 0m||£ 0.5m||£ 1m||£ 1m|
Project A pays back in 3 years (£ 0 in year 1 + £ 0.5m in year 2 + £ 0.5m in year 3).
Project B pays back in 2 years (£ 0.5m in year 1 + £ 0.5m in year 2).
Project C pays back in 3 1/2 years (£ 0 in year 1 + £ 0 in year 2 + £ 0.5m in year 3 + half of the £ 1m in year 4).
Using 'The Pay-back Method' to decide between these projects, project B would be selected. But if you looked at the total revenue over the full life of each project, project C actually brings more cash into the business and would be the better project to select.
This method takes the total return (yield) over the whole life of the asset into account and therefore overcomes one of the defects of the payback method.
In order to understand the arithmetic, consider an item of capital (e.g. a machine) which will cost £ 1 million to purchase, is expected to last 5 years, and will produce an annual net cash flow of £ 0.5 million.
The total return (yield) is: 5 x £ 0.5 million = £ 2.5 million
If we now deduct the initial cost of investment (£ 1 million) we are left with a total return (yield), net of the initial capital outlay, of £ 1.5 million.
Annually, this works out at:
When we express this annual figure as a percentage of the original capital outlay we get the Average Rate of Return for the project:
To recap, the 4 steps for calculating the A.R.R. are:
Add up the total forecasted net cash flow
Deduct the capital outlay from this
Divide the resulting figure by the expected life (in years) of the capital
Express this annual figure as a percentage of the capital outlay
As with the Payback method, we can use the A.R.R. in two ways. Firstly, the firm might set a predetermined level and reject any project which has an expected A.R.R. less than this percentage. Secondly, when faced with a choice of alternative projects, then the projects can be ranked by their A.R.R.
Further examples. A firm is considering three alternative investment projects. The maximum life of each asset is three years and the capital outlay is £ 100,000 in each case. The table below depicts net cash flow in each of the three years:
|PROJECT||YEAR 1||YEAR 2||YEAR 3|
|A||£ 50,000||£ 50,000||£ 50,000|
|B||£ 100,000||£ 20,000||£ 0|
|C||£ 0||£ 50,000||£ 140,000|
Total forecasted net cash flow = £ 150,000
Total forecasted net cash flow - capital outlay = £ 50,000
£ 16,666.67 (this is the amount of profit per year)
Total forecasted net cash flow = £ 120,000
Total forecasted net cash flow - capital outlay = £ 20,000
£ 6,666.67 (this is the amount of profit per year)
Total forecasted net cash flow = £ 190,000
Total forecasted net cash flow - capital outlay = £ 90,000
£ 30,000 (this is the amount of profit per year)
The great defect of the A.R.R. method of investment appraisal is that it attaches no importance to the timing of the inflows of cash. A.R.R treats all money as of equal value, irrespective of when it is received.
Hence, a project may be favoured even though it only produces a return over a long period of time.
The more sophisticated methods of investment appraisal take the timing of the cash inflows into account, as well as the size of the inflows.
A sum of money in one year's time is worth less than that same sum of money now (i.e. inflation will erode the real value of that sum of money over the year). This is where the notion of present value is used.
The return on an investment comes in the form of a stream of earnings in the future. The N.P.V. method of investment appraisal takes into account the size of the cash inflows over the life of the equipment, but also makes adjustment for the timing of the money. A greater weighting (or importance) is given to the inflows of cash in the earlier years.
The weighting can be calculated from the following formula:
A = the actual sum of money concerned
r = the rate of discount (called the 'Discount factor')
n = the number of years
This enables us to calculate the present value of money, net of operating costs, to be received in a certain number of years. Hence, £ 1000 in two years time, at a 3% rate of discount, has a present value of:
In examinations you will usually be given the discount factor, so that you do not have to work it out!
The present value of each year's cash inflow are then aggregated (this is called the discounted cashflow, or D.C.F) and this figure is compared with the initial capital outlay. If the sum of present values (minus the capital cost) is positive, then it is worthwhile proceeding with the project. If the resulting figure is negative, then the project should not be undertaken.
In appraising a £ 300,000 investment project, a firm uses a discount rate of 5%. The equipment will produce a cash inflow (net of operating costs) of £ 75,000 per year, over a five year period. At the end of the five years, the firm expects to sell the equipment for £ 10,000. What is the Net Present Value of the project?
|0||-£ 300,000||-£ 300,000|
|1||+£ 75,000||+£ 71,428.57|
|2||+£ 75,000||+£ 68,027.21|
|3||+£ 75,000||+£ 64,787.82|
|4||+£ 75,000||+£ 61,702.69|
|5||+£ 85,000||+£ 66,599.72|
Year 0 is the present day (i.e. when the initial capital outlay is spent).
The cashflow of £ 75,000 in year 1 has a present value of:
The cashflow of £ 75,000 in year 2 has a present value of:
The process continues for the remaining years.
The discounted cashflow is the sum of the present values for the 5 cash inflows (i.e. from year 1 to year 5).
This figure is £ 332,546.01
The net present value is found by deducting the initial capital outlay from the discounted cashflow. In other words:
£ 332,546.01 - £ 300,000 = £ 32,546.01
Since this result is positive, then it is advisable for the firm to go ahead with the investment project. If the result had been negative, then the investment project should not be undertaken.
There are many other factors that a business will need to take into consideration when appraising an investment project, other than the financial (quantitative) factors.
Qualitative factors such as the objectives of the business must be considered at all times, as well as the effect upon the employees of new machinery, new working practices and changes to their working conditions.
The external environment needs to be considered before any decision can be taken regarding a proposed investment project.
These factors include the state of the economy (e.g. it may be dangerous to attempt to expand during a recession, because demand for products may be falling), pressure group activity, the level of technological progress in the industry (e.g. competitors may already be using the new machinery), and any legislation (e.g. restricting the use of certain materials, components).
The effects of the actions of the business on the environment must also be taken into consideration, since any external costs (e.g. pollution) will have a detrimental effect on the image and reputation of the business.
Finally, as with any investment decision, the business will also need to consider the amount of finance that is available for expansion, and the effect that any borrowing to raise extra finance will have on the gearing ratio.