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.
YearCash Flow DetailCash flow £Cumulative Cash FlowPayback?
0Investment (cash out)(500,000)(500,000)No
1Net Cash Inflows100,000(400,000)No
2Net Cash Inflows150,000(250,000)No
3Net Cash Inflows175,000(75,000)No
4Net Cash Inflows150,00075,000Yes

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

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