Investment appraisal.

[check] This checklist is for all managers who wish to carry out an investment appraisal. In today's increasingly competitive business environment, getting the most from available resources is one of the keys to business success.

Managers need to use a mix of skills when conducting investment appraisals--gathering information; carrying out financial analysis; writing a business plan and making recommendations--all key management skills.

Definition

Investment appraisals are conducted to assess whether it is worthwhile making an investment. Such investments usually involve a large initial payment of cash, followed by later receipts or payments. These later receipts or payments are related to, or arise from, the original investment.

For instance, an organisation could invest in a marketing campaign which might lead to an increase in sales receipts over the following three years.

Advantages of conducting investment appraisals

* Cash and other resources are invested in the most profitable projects.

* Realistic project budgets are established.

* Risks arising from the investment are considered and measures can be taken to eliminate the risks, and/or reduce their impact.

Disadvantages of failing to conduct investment appraisals, (or conducting inadequate appraisals)

* Cash and other resources are invested on sub-optional projects.

* Subjective and unfair decisions may be made.

Action checklist

1. Identify the key plans and objectives for the organisation

Identify objectives and plans so that you can assess whether your investment proposal fits in with them. You also need to consider whether there are alternatives to your proposal. Assess payments, receipts and duration of the investment project

Assess the duration of the project and list all estimated payments and receipts which are relevant to it.

Some payments and receipts will be relatively straightforward to identify. For instance, an investment in a new retail store will lead to cash receipts from sales over a number of years, and payments for staff wages, maintenance, goods for resale, etc. As tax payments or tax receipts and inflation also need to be considered, you may need to enlist the help of an accountant.

Other costs and benefits arising from the investment will be more difficult to identify and estimate. For example, an investment in a high-tech system may lead to an increase in productivity and morale. If costs and benefits such as these are difficult to quantify in monetary terms, notes should be attached to the investment appraisal to highlight them.

2. Produce a cash flow forecast and profit & loss account for the project

A cash flow forecast that allocates receipts and payments to months (or years) should be produced. If you intend to calculate the Accounting Rate of Return, a forecast profit & loss account also needs to be produced. This also needs to be segregated into months (or years).

3. Establish the methods that your organisation uses to appraise investments

The most common methods of investment appraisal are listed below. They can be divided into those that use cash flow forecasts and those that use profit & loss account forecasts.

Methods that use cash flow forecasts:

i) Payback Point--this measures the point at which cumulative cash receipts equal cumulative payments. Proposals with a shorter payback period are generally preferred.

Example

A company is considering purchasing an asset. At the outset it will pay out 100k [pounds sterling] and have inflows of 70k [pounds sterling] after a year, and a further 52k [pounds sterling] after two years. At this point, the asset will be scrapped. The company applies a discount rate of 10% when calculating Net Present Value.

Should it make the investment?

The payback point is when cumulative outflows equal cumulative inflows, ie the point at which the project starts to make a surplus, as follows:</p>

<pre> (All figures are [pounds sterling] 000)

Outset Year 1 Year 2 TOTAL Inflows

- 70.0 52.0 122.0 Outflows

(100.0) - - (100.0) Net (100.0)

70.0 52.0 22.0 Cumulative Cash Flow (100.0) (30.0)

22.0 </pre> <p>The payback point appears some time during Year 2. If we assume that the inflow of 52k [pounds sterling] occurs evenly during Year 2, we can estimate the point at which payback occurs. We need 30k [pounds sterling] of the 52k [pounds sterling] to reach that point. This occurs after 30/52ths of Year 2, or after 30 weeks, or after 30/52 x 12 = 7 months of Year 2. Payback period is therefore 1 year and 7 months.

ii) Net Present Value (NPV)--this method recognises that a) the organisation has a 'cost of capital,' ie one can imagine that the cash for the investment is borrowed and therefore interest needs to be paid on the borrowing, b) cash receipts and payments in the future may be subject to inflation, c) some investments may be riskier than others. For instance, it is riskier for a company to diversify into a new product or service. After considering a), b) and c), a 'discount rate' will be decided upon, and applied to the cash flow forecast to give the Net Present Value of the project, ie the [pounds sterling]s return from the project in today's values. Proposals with a higher Net Present Value are generally preferred.

Example

All figures are 000s [pounds sterling] except discount factor (Disc. Factor). The discount factor is taken from published discount tables.</p>

<pre> NOW Year 1 Year 2 TOTAL Inflows

- 70.0 52.0 122.0 Outflows

(100.0) - (100.0) Net (a) (100.0)

70.0 52.0 22.0 Disc. Factor @ 10%

1.000 0.909 0.826 (b) NPV (a x b) (100.0) 63.6 42.9 6.5 </pre> <p>The project has a net present value of 6.5k [pounds sterling]. This means that after allowing for the cost of borrowing at 10%, the project still makes a surplus of 6.5k [pounds sterling] at today's value.

iii) Internal Rate of Return (IRR)--this method uses discounting techniques (see Net Present Value above) to calculate the percentage return from an investment. Proposals with a higher Internal Rate of Return are generally preferred.

We know from the Net Present Value calculation that the project will make sufficient returns to pay interest on borrowings at 10% and still make a surplus. The internal rate of return of the project is the borrowing rate that the project could just afford to pay, or one could say that it is the actual rate of return on the project. Looking at this in another way, it is the discount factor that is used to produce a project net present value of zero.

One can arrive at an IRR by trial and error, ie by changing the discount factor until it produces a net present value of nil. In this case, the internal rate of return is 15%.

Example

All figures are 000s [pounds sterling] except discount factor. The discount factor is taken from published discount tables.</p> <pre>

NOW Year 1 Year 2 TOTAL Inflows

- 70.0 52.0 122.0 Outflows

(100.0) - - (100.0) Net (a)

(100.0) 70.0 52.0 22.0 Disc. Factor @ 15% (b)

1 0.869 0.756 NPV (a x b) (100.0) 60.8 39.3 0.1

(ie approx nil) </pre> <p>Method that uses profit & loss account forecasts:

iv) Accounting Rate of Return (ARR)--this calculates a percentage return which is similar to Return on Capital Employed. Proposals with a higher ARR are generally preferred. NB: You may need to ask an accountant to assist with these methods. Spreadsheets can usually calculate the NPV and IRR for you.

Example: Project Profit & Loss Account Estimate (all figures in 000s [pounds sterling])</p> <pre> Year 1 Year 2 TOTAL Sales 70 52 122 Costs Depreciation

50 50 100 Profit: 20 2 22 </pre> <p>Accounting Rate of Return calculation:

Average Return (profit)/Average Invested = = (20k [pounds sterling] + 2k [pounds sterling] / 2 x100/100k [pounds sterling / 2*

= 11k [pounds sterling]/50k [pounds sterling] x 100(%) = 22.0%

* This shows the average amount invested over the lifetime of the asset. If the amount invested at the start is assumed to be 100k [pounds sterling], and the amount invested is assumed to be nil at the end of the project, then the average amount invested will be 50k [pounds sterling].

Why would companies wish to consider the Accounting Rate of Return rather than the simpler methods of Payback, Net Present Value and Internal Rate of Return?

Internal and external analysts usually use profit & loss accounts to measure the performance of the business. They will calculate ratios such as Return on Capital Employed (ROCE). The Accounting Rate of Return gives an approximation for an asset purchase or project and the effect on the company's overall ROCE can be assessed. If the asset purchase (or project) rate of return is higher than the company's normal ROCE, it is likely to be accepted.

4. Should the company make the investment?

The company would consider a number of factors including whether it has (or can obtain) the initial cash to purchase the asset. It would also consider other possible investments, may use some or all of the above techniques and would tend to invest in assets (or projects) that have a:

* shorter payback period

* higher Net Present Value

* higher Internal Rate of Return

* higher Accounting Rate of Return.

5. Include your calculations in a business plan for your proposal

Any substantial investment proposal should be incorporated either in the department's overall business plan or in a separate plan which, in addition to the purely financial calculations, should detail the costs (staff, time) and anticipated non-financial benefits, eg greater efficiency.

Do's and Don'ts for Investment Appraisal

Do

Consider all cash flows arising from the investment.

Give full consideration to non-financial factors, such as an increase in morale.

Enlist an accountant's help.

Don't 

Forget to consider inflation, taxation and risks.

Forget to consider alternatives to your proposal. Is there a different way of achieving the objective?

Useful reading

Investment appraisal: a managerial approach, Richard Pettinger

Hampshire, MacMillan, 2000

Investment appraisal for non-financial managers: a step by step guide, Kate 

Moran 

London: Prentice Hall, 2000

Thought starters

* Does your proposed investment fit in with your organisation's strategic objectives?

* Have you looked at previous proposals to see which techniques your organisation uses?

* Do you know how your organisation allows for risk and inflation in investment proposals?