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uk

Project Investment Appraisal

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Financial Investment Appraisal

A means of assessing whether an
investment project is:
financially viable
The best option available

Complements other Project

Investment Decisions

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Other Investment Decisions

Product Portfolio
Fit to current products
Complementary to portfolio
Not internal competition
Targets new market segments

Can be supported by existing manufacturing /

distribution arrangements
Does not divert essential resources from other
projects

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Other Investment Decisions

Company Resource Limits
Cash
Skills
Equipment
Management Time

Company Strategies
Does it deliver required future sales growth
Does it deliver required future profit growth
Will it extend product lifecycles

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Other Investment Decisions

Corporate Image
Will this project enhance / damage the
companys image with:
Investors?
Customers?

Risk
Does this project contribute to a balanced
risk portfolio?
Is the risk within corporate acceptance
boundaries?

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Other Investment Decisions

Is this project consistent with
companys position on innovation
Leader or follower?

Time Gearing
Will the project pay back the investment
in the timescales desired
Will the project reach market in time to
beat competitors

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Other Appraisal Criteria

Marketing Criteria
Identifiable customer needs exist
Estimated market size is large enough to
justify investment
Market share projection is reasonable
Competitors are not entrenched
Consistency with marketing plans
Addresses weaknesses in existing market
offerring

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Other Appraisal Criteria

Launch Costs
Reasonable launch costs

Technical Assessment
Reasonable prospects of technical
success
Competitive technology offering
Patent protection / future technology
developments

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Other Appraisal Criteria

Legislation
Does the product anticipate future
legislation
Are there imminent legislation
requirements?

Manufacturing Assessments
Cost of new facilities
Utilisation of existing facilities

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Investment Appraisal
Types of investment appraisal:
Payback Period
Accounting Rate of Return (ARR)
Internal Rate of Return (IRR)
Profitability Index
Net Present Value (discounted cash
flow)

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Investment Appraisal
Assumptions:
Investment will yield future income
streams
Marketing or engineering studies indicate
predicted returns

Comparison of future income streams

against the cost of the investment
Therefore, an estimate only!

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Payback Method
The length of time taken to repay
the initial capital cost
Requires information on the revenue the
investment generates
E.g. A machine costs 600,000
It produces items with 5 profit each
and produces 60,000 units per year
Payback period will be 2 years

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Payback Method

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Payback Pros & Cons

Advantages:
Simple to compute
Easy guidelines to lower manages to
operate
Widely accepted technique
A risk averse method

Disadvantages:
Ignores total profits made
All profits after payback period are not counted
Lower total profit projects can be preferred

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Accounting Rate of Return

A comparison of the profit
generated by the investment with
the cost of the investment
Average annual profit

ARR = -------------------------------------------Initial cost of investment

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Accounting Rate of Return

e.g.
A investment is expected to yield profits of
10,000 annually for the next 5 years.
The initial cost of the investment is 20,000
Total profit therefore is: 30,000
i.e. 50,000 (total profits) - 20,000 (investment)

Annual profit = 30,000 / 5

= 6,000
ARR = 6,000/20,000 x 100
= 30%
A worthwhile return?

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Net Present Value

The Principle - Deferred income is
worth less than income now
Takes into account the fact that money
values change with time
The Present Value of money is related
to interest rates

Shows you what your investment

would have earned in an different
investment

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Net Present Value

The principle:
Invest 100 at 10%
Future values will be:
110 at end year 1
121 at end year 2
Etc..

Therefore 110 in 1 years time is

worth 100 to you today!!
i.e. The Present Value = 100

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Present Value
Future Value
PV = ----------------(1 + i)n
Where i = interest rate
n = number of years
The PV of 1 @ 10% in 1 years time is 0.9090.
Referred to as:
Discounted Cash Flow

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Net Present Value

The NPV is the sum of the present value of all
future returns (profits)
NPV =

PVi

Rule:
Approve project if NPV is positive over agreed
timeframe
Reject project if NPV is negative over agreed
timeframe

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NPV Example

Project rejected because NPV is negative

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Internal Rate of Return

Allows the risk associated with an investment
project to be assessed.
The IRR is the rate of interest (or
discount rate) that makes the net present
value = to zero
Helps measure the worth of an investment
Allows the firm to assess whether an
investment in the machine etc would yield a
better return based on internal standards of
return

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Internal Rate of Return

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IRR Pros & Cons

Advantages:
Avoids the need to set a true cost of
capital
Only needs an internal threshold rate

Disadvantages:
It is not related to the size of a project
Does not rank projects if cash flow
trends differ

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NPV - Profitability Index

Used for ranking projects by NPV
Allows a comparison of the costs and
benefits of different projects to be
assessed and thus allow decision
making to be carried out
Net Present Value
Profitability Index =

-------------------Initial Capital Cost

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Investment Appraisal
Key considerations for firms in
considering use:

Ease of use/degree of simplicity required

Degree of accuracy required
Extent to which future cash flows can be
measured accurately
Extent to which future interest rate
movements can be factored in and
predicted
Necessity of factoring in effects of inflation