The process of analysing whether investment projects are worthwhile.
Annual Average Rate of Return (ARR)
- The annual percentage return on an investment project based on average returns earned by the project
Calculating and interpreting ARR
- Calculate the average annual profit from the investment project
- Divide the average annual profit by the initial investment outlay
- Compare with the target percentage return
Discounted Cash Flow (NPV)
Net present value (NPV) calculates the monetary value now of a project’s future cash flows.
- Discounting is the method used to reduce the future value of cash flows to reflect the risk of inflation or the investment not working out.
The Time Value of Money
- Better to receive cash now than in the future
- Future cash flows are worth less
- Use discount factors to bring cash flows back to their present value
- Relevant discount factor determined by required rate of return
Calculating the present value of a future cashflow
Formula
Cash Flow x Discount Factor = Present Value
If NPV is positive, then the investment is worth doing. If NPV is negative, then the investment is not worth doing.
If you have a choice between two positive NPV projects, then you want the one with the highest NPV.
Payback Period
- Identify the net cash flows for each period (eg, a year)
- Keep a running total of the cash flows
- Initial investment is an outflow
- When does the running total move from negative to positive (outflows)
- When the total net cash flow becomes positive, that is the end of the payback period.
| Year | Cash Flow Detail | Cash flow £ | Cumulative Cash Flow | Payback? |
|---|---|---|---|---|
| 0 | Investment (cash out) | (500,000) | (500,000) | No |
| 1 | Net Cash Inflows | 100,000 | (400,000) | No |
| 2 | Net Cash Inflows | 150,000 | (250,000) | No |
| 3 | Net Cash Inflows | 175,000 | (75,000) | No |
| 4 | Net Cash Inflows | 150,000 | 75,000 | Yes |
In this case, there is an overshoot. It took 3 and a bit years to reach payback. We can tell because there is more than 0 at the end of year 4.
Formula
Payback Period = Initial Investment / Annual Cash Flow
Benefits of payback period
- Simple and easy to calculate
- Focus on cashflows
- Easy to understand the results
- Emphasises speed of return; good for fast moving markets
- Straightforward to compare competing products
Drawbacks of payback period
- Ignores cash flows after payback has been reached
- Takes no account of the “time value of money”
- May encourage short-term thinking
- Ignores qualitative aspects
- Does not actually create a decision for the investment.
Calculating and Interpreting ARR
- Calculate the total net inflow from the project
- Deduct the outlay (initial investment) to get the annual profit
- Divide the total annual profit by the total number of years to get the average annual profit
- Divide the average annual profit by the initial investment (“outlay”)
- Compare with the target percentage return