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Investment Appraisal Techniques

Investment Appraisal Techniques. TOPIC: Topic 3: Accounts & Finance LESSON TITLE: Investment Appraisal LEARNING INTENTION: To understand what investment appraisal is and to be able to use IA techniques to calculate payback on investment. COMPETENCY FOCUS:

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Investment Appraisal Techniques

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  1. Investment Appraisal Techniques

  2. TOPIC: Topic 3: Accounts & Finance LESSON TITLE: Investment Appraisal LEARNING INTENTION: To understand what investment appraisal is and to be able to use IA techniques to calculate payback on investment. COMPETENCY FOCUS: Key Skills (Numeracy): to develop your numeracy skills through the calculation of investment appraisal techniques. [IB Learner Profile Development: Logical] Success Criteria By the end of the lesson, I can… 1) Define the term investment appraisal 2) Explain why investment appraisal is calculated by businesses 3) Calculate the payback period of an investment. SMSC: You will assess the state of the organisation’s financial investments using calculations. CRITICAL THINKING KEY: Knowledge ApplicationAnalysis Evaluation

  3. Investment Appraisal What do you understand by the term Investment Appraisal? Investment appraisal involves a series of techniques, which enable a business to evaluate the profitability of an investment.

  4. Investment Appraisal It is a techniques use to determine if a particular investment is worthwhile. It can be used to compare different projects to determine which is more favourable.

  5. Types of Investment Appraisal Techniques? • Payback Period (PBP) • Accounting Rate of Return (ARR) • Net Present Value (NPV)

  6. Advantages of the payback method Payback is an easily understood concept. The calculation is quick and simple Shorter-term forecasts are likely to be more reliable. It is a measurement of Investment risk as risk is increased if payback is longer. A business may have borrowed money from bank to fund the investment therefore a longer payback will increase interest payments.

  7. Disadvantages of the payback method It ignores the timing of cash flows within the payback period. It also ignores the cash flows after the end of the payback period and therefore the total project return. It ignores the time value of money. This means that it does not take account of the fact that £1 today is worth more than £1 in one year's time. The method is unable to distinguish between projects with the same payback period. It may lead to excessive investment in short-term projects.

  8. Example • What is happening in yr0? • How long will it take for the initial investment to be covered and a profit is starting to be made?

  9. Practice Question Calculate the PBP for the two projects.

  10. What if the payback period falls between 2 years? Amount required Net Cash Flow in Year x12 =

  11. Now have a go… Case study P189 Question 1 P193 Question 1

  12. TOPIC: Topic 3: Accounts & Finance LESSON TITLE: Investment Appraisal - ARR LEARNING INTENTION: To understand what investment appraisal is and to be able to use IA techniques to calculate payback on investment. COMPETENCY FOCUS: Key Skills (Numeracy): to develop your numeracy skills through the calculation of investment appraisal techniques. [IB Learner Profile Development: Logical] Success Criteria By the end of the lesson, I can… 1) To define ARR 2) To calculate ARR (average rate of return). SMSC: You will assess the state of the organisation’s financial investments using calculations. CRITICAL THINKING KEY: Knowledge ApplicationAnalysis Evaluation

  13. Accounting Rate of Return (ARR) Accounting Rate of Return (ARR) expresses the average profit per annum as a percentage of the capital outlay. The decision rule (criterion rate) is that projects with an ARR above a defined minimum as set by the organisation are acceptable; however the general rule is that the greater the ARR, the more desirable the project.

  14. Calculating the accounting rate of return ARR = (total returns – capital outlay) Years of usage x100 Capital Cost

  15. Practice Questions

  16. Advantages It is quick and simple to calculate. It involves a familiar concept of a percentage return. Accounting profits can be easily calculated from financial statements. It looks at the entire project life

  17. Disadvantages It is based on accounting profits rather than cash flows, which are subject to a number of different accounting policies. It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment. It takes no account of the length of the project. Like the payback method, it ignores the time value of money

  18. Practice Questions Pg189 Activity 19.2 [Old book] Pg239 Question C [New book]

  19. TOPIC: Topic 3: Accounts & Finance LESSON TITLE: Investment Appraisal – NPV (HL ONLY) LEARNING INTENTION: To understand what investment appraisal is and to be able to use IA techniques to calculate payback on investment. COMPETENCY FOCUS: Key Skills (Numeracy): to develop your numeracy skills through the calculation of investment appraisal techniques. [IB Learner Profile Development: Logical] Success Criteria By the end of the lesson, I can… 1) To define NPV 2) To calculate NPV (net present value). SMSC: You will assess the state of the organisation’s financial investments using calculations. CRITICAL THINKING KEY: Knowledge ApplicationAnalysis Evaluation

  20. Net Present Value (NPV) • Risk – money in the future is uncertain. • Opportunity cost –could be in an interest account earning interest. • Therefore… today’s value of the investment! This takes into account the time value of money. It is based on the principle that money is worth more now than it is in the future. The principle exists for two reasons:

  21. Net Present Value (NPV) NPV=PVCI-PVCO • If the NPV is positive, it means that the cash inflows from a project will yield a return in excess of the cost of capital, and so the project should be undertaken. • If the NPV is negative, it means that the cash inflows from a project will yield a return below the cost of capital, and so the project should not be undertaken. • If the NPV is exactly zero, the cash inflows from a project will yield a return which is exactly the same as the cost of capital. NPV = present value of cash inflows minus present value of cash outflows.

  22. Advantages Considers the time value of money. It considers all relevant cash flows, so that it is unaffected by the accounting policies which affects profit-based investment appraisal techniques such as ARR Reducing discounting rate reduces future monies more heavily. Only one method that gives a definitive answer. Positive return – it is worth doing

  23. Disadvantages Time consuming. More difficult to understand. Based on an arbitrary choice of interest rate.

  24. Practice Questions

  25. Case Study Read case study on pg.193. Respond to comprehension questions. 1hr

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