Chapter 35 - Investment Appraisal
Learning Objectives: To understand the investment appraisal techniques of payback period
Investment Appraisal is the practice of assessing financial feasibility of projects and businesses. It includes quantitative and qualitative techniques to show whether the likely future returns on a project/business are greater than its costs.
Quantitative methods of appraisal seek to prove whether the expected inflows of a project will surpass its outflows (costs). For that, some key information is necessary:
Initial Capital Cost - which in the case of machinery should include installation costs;
Estimated Life Expectancy of the project which is how long will it yield returns for;
Forecasted Net Cash Flows which is found by subtracting the annual running costs of the project from its expected returns;
Residual Value of the investment;
There are five quantitative investment appraisal techniques:
Payback Period;
Average Rate of Return (ARR);
Discounted Payback;
Net Present Value (NPV);
Internal Rate of Return (IRR).
The basis for any of these techniques is cashflow forecast in which inflows are represented by revenues earned from the project and outflows are its operating costs and capital cost.
Can you see a problem with that, though?
Cashflows can become very inaccurate - specially when considering long-term projects:
- Economics recessions;
- Rising prices of commodities (e.g. oil);
- Competition actions impacting the success of a project.
Activity 35.1 - Discussion
Let's dive in by understanding the first quantitative technique: Payback Period which is the length of time it takes for the net cash inflows to pay back the original capital cost of the investment.
Example:
A company makes a $500,000 investment in a new equipment.
Here is the forecasted cashflow for such investment/project:
At the time of the capital expenditure cashflow is negative (year 0);
Year 1 inflow = $300,000;
Year 2 inflow = $150,000
Year 3 inflow = $150,000 - the project becomes cumulatively profitable meaning the capital cost paid back on year 3.
The problem is: when on year 3?
If cash inflow is believed to happen evenly through the year ($12,500) the payback will happen exactly at the fourth month of year 3:
Year 2 closes with ($50,000) which when divided by $12,500 = 4.
You can also use the following formula to find the exact payback time (month):
Is this information useful for businesses, though?
Payback Period offers businesses many insights:
Ability to compare with other projects;
Assessment of whether debt finance should be taken to carry on this project;
Opportunity cost;
Long Payback Periods reveal risky projects (higher chances of external impacts);
Risk-averse managers prefer short payback in their investments.
Considerations regarding inflation should be made: future cash inflows are less valuable than today's cash inflow - the quicker the payback the higher the real value of the project will be.
Payback Period, therefore, is quick, easy, and the most common method of investment appraisal. It should, therefore, be combined with other methods to be precise.
Activity 35.2
Evaluation on Payback Period
To-Do-List
Evaluate the investment appraisal technique payback period [12].
Chapter 35 - Investment Appraisal
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