What is investment appraisal?

Investment appraisal is the process of evaluating the profitability

and feasibility of a project before making an investment decision.

35.2 Quantitative Techniques: Payback Period and Accounting Rate of Return

Payback Method (Payback Period)

Payback Period = Year before break-even point + (Uncovered amount / Annual cash flow of the
break-even year)
= 2 + 50000/150000 = 2.3 years translated to 2 years and 4 months

- Shorter payback period suggests that the break-even point of the initial investment can be
achieved earlier, therefore, the project generates profits faster than the others.
- Most of the business projects are financed by bank loans, which require annual interest
payment. The longer payback period indicates that the business will have greater total
interest expenses, reducing the profitability of the whole project.
- If the project is financed internally, there are still opportunity costs of other purposes
which the capital could have been used for. Therefore, a shorter payback period offers
quicker positive cumulative cash flow that can be used to fund other projects.
- Projects with longer payback period are often associated with high degree of risks:
+ Longer timeframe increases the accuracy of cash flow forecasts, therefore,
making the expected payback period longer than planned.
 + Interest expenses
+ The project will be exposed to more unexpected change of the external
environments
- Quicker return of the money is equal to higher present value owing to time value of
money and inflation.

Advantages of the methods

- Compared to other quantitative techniques, the payback period is fairly easy to calculate
and understand by managers.
- Focusing on the liquidity of the investment projects, especially beneficial if shareholders
prefer projects with the total costs that can be covered quickly. By using the payback
period, the business can compare the time required for each project to reach their break-
even of the initial investment, allowing them to identify the project that is associated with
least risk while preventing extended periods of payment.
- The technique can be performed quickly by the business, facilitating fast decision-making
within a dynamic environment.
- Focusing on the liquidity that can be achieved quickly can help the business to minimize
the risk of market changing that they are exposed to. (Highly appropriate if the
external environment is uncertain)
Limitations
- The technique ignores the cash flow after the payback period, therefore, does not reflect
the actual profitability in the long-run of the project.
- Therefore, the payback period might mislead the business to reject profitable investment
and focus only on the short-term projects.
- Payback period does not consider the time value of money, making the estimated future
cash flow less accurate in representing the actual value of the project.

Accounting Rate of Return (Return on Investment)

Formula:

- Average annual profit = Total profit (Total Cash Inflow - Total Initial Investment)/ Life-
expectancy of the project
- Average investment = (Initial investment + Residual capital value “salvage value”)/2
- ARR suggests the approximate return on investment of a project “profitability”

Advantages and applications:

- Compared to the payback period, the technique considers the cash flows within the life
cycle of a project, providing a more all-rounded evaluation of its profitability.
 - Focusing more on profitability rather than only liquidity. The technique helps businesses
to identify the most profitable project, emphasizing the importance of profitability during
the life of a project.
- Can be compared to the cost of finance and other investment to decide whether the
project is worth the commitment. (If the ARR is lower than the average cost of finance,
the business will be experiencing financial losses)
- Easy to calculate and can be understood by managers and the shareholders.
- Can be compared to the criterion rate of return, facilitating the filtering of business plans
and investment projects.

Limitations
- The cash flows in ARR are not discounted, therefore, not including the time value of
money, making the future cash inflow overvalued.
- Sometimes including the forecasts of the far future, making the cash flows less accurate
and reliable, especially if the business or the market is exposed to external uncertainties.
- Ignoring the timing of cash flows, resulting in a project that might generate high rate of
return in the later years but struggling in performing during the initial years to cover the
capital investment (Financial constraints).

Discounted cash flow

- Discounted cash flow: The present-day value of a future cash flow by using the principal
of time value of money.
- Rate of risk-free investment: Government bonds, cost of finance, etc
- Formula to calculate discount rate for each year (giving interest rate or initial discount
rate)
1
Discount rate of year n = n
(1+interest rate)❑
 - If the cash flows are discounted before calculating ARR, the calculation becomes IRR
(Internal Rate of Return), where the time value of money has been considered.

Net present value (NPV)

- Indicating the total return of a project that is illustrated in the present-value
- Formula: Total discounted cash flows - Total original investment = NPV
- By using NPV, the business can eliminate the proposals with negative returns in terms of
present-value, where the investment is not worth regarding the given discount rate (the
investment could have been allocated in risk-free investment and provide better yields)
Advantages of using NPV
- Net present value includes the principle of time value of money: Discounting future cash
flows make the evaluation of a project’s profitability more realistic and accurate,
avoiding the misleading caused by large number of returns (but the discounted value
might be smaller than expected)
- Allowing the comparison between projects with different time-frames: Projects with
longer life-expectancy might not generate the amount of return as expected after being
discounted since they are farer in the future.
- Facilitating the calculating of IRR (the account rate of return but with discounted cash
flows)
- The discount rates applied in the calculation can be adjusted in accordance to the
economic circumstances. For instance, if the business is expecting the bank interest rate
or government bond interest rate to increase in the next following years, they can
incorporate a higher discount rate in their present calculation, leading to a more accurate
forecast of future cash flows.
Limitations
- The reliability of the NPV depends greatly on the selection of discount rates, therefore,
overestimating or underestimating the future discount rates might result in overvalued or
undervalued NPV of a project.
- Complexity owing to the forecast and calculation of discounted cash flows, making the
results highly unreliable and the analysis inaccurate.
- NPV cannot compare two projects with different initial costs since it does not provide the
percentage of return regarding the total investment. Recommending to calculate the
percentage return or the average rate of return of the discounted cash flow (IRR).

Comparison between the three quantitative techniques

- The payback period is appropriate for firms that want to avoid liquidity issues and are
operating in uncertain markets. (Short-term horizon)
- ARR and NPV emphasize the importance of profitability, a factor that most of the
shareholders are encouraged by.
- ARR and NPV do not consider the timing of cash flows, however, the cash flow forecasts
are included during the calculation of both indicators. Therefore, the cash flow forecast
 tables should be included and considered by the managers to avoid cash flow problems
that might occur during the project.
- Both of the three quantitative techniques do not consider qualitative factors.
- Other factors to consider:
+ Financial performance analysis
+ Available sources of finance and their costs

Qualitative factors in investment appraisal

- Impacts on the environment: A business project might negatively affect the nearby
environment, causing pressure groups, environmental activists or the government to
pressure the business operational. The outcomes range from damaged reputation to
environmental taxes, increasing the operational and indirect costs for the project and
reducing its successability.
- Infrastructure and transportation: Well-developed infrastructure and transportation
facilitates a smooth setup for the supply chain management of the new project, increasing
its feasibility and opportunities for future expansion if desired.
- Impacts on the workforce: Depending on the effects of the project on the current
workforce. For instance, some projects or proposals might be related to the replacement
of the workforce with machinery, leading to redundancy and damaging the relationship
between the business and its employees.
- Impacts on the local community and the business CSR:
- Internal and external analysis (SWOT, PEST and Core Competencies)
- Objectives of the business: Maximizing the returns to shareholders (Profitability),
Sustainability (CSR), short-term objective of improving liquidity and avoiding
bankruptcy.