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Investment appraisal

Investment appraisal. Chapter 19. Shoplifting (UK) Cost UK businesses £4.4bn / year (£4,400,000,000) More than a third of all goods stolen are by shop employees Shoplifting prevention adds £180 to each household's annual shopping bill

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Investment appraisal

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  1. Investment appraisal Chapter 19

  2. Shoplifting (UK) • Cost UK businesses £4.4bn / year (£4,400,000,000) • More than a third of all goods stolen are by shop employees • Shoplifting prevention adds £180 to each household's annual shopping bill • The most stolen items are branded clothing, cheese, alcohol and seafood. • The average shoplifter will steal £100 in one spree • £970m (£970,000,000) was spent on increased security last year which resulted in a 5% decrease in the value of items stolen. was the £970m spent on improved security worth a 5% reduction?

  3. Investment appraisal Evaluating the profitability / desirability of an investment. • Quantitative measurements: • The initial capital costs • The annual net returns • (do the cash inflows subsidies the additional cash outflows) • The life expectancy • How many years will it take to recover the initial investment?

  4. Annual forecasted net cash flow Cash inflow Cash outflow Forecasting cash flow is never accurate. There are too many external variables which affect the net cash flow of a business.

  5. Consider what other factors affect the net cash flow for… London currently has five airports. The government is debating whether or not to build a sixth. What are the factors the government are considering? • An economic recession would reduce the amount of passengers, thereby reducing the need for a sixth airport. • Increased oil prices are continually making flights more expensive, therefore less passengers. • Improved other modes of international transport (high speed rail / channel tunnel / ferries) • Another airport would reduce congestion, and allow more flights to land, more passengers? • Creates employment, helps local and wider economy • Terrorist attacks have reduced the desirability to fly

  6. Payback period A project costs $2,000,000 and is expected to payback $500,000. We can see that the cash flow becomes positive in year 3. To calculate exactly when we look at year 2, they need an additional 50,000 for the cumulative cash flow to be 0. So as soon as they reach 50,000 in year 3, the cumulative cash flow will be 0. anything after that will be a positive cash flow. Additional cash inflow needed Annual expected cash flow X 12 50,000 150,000 X 12 = 4 months

  7. Payback period will help to determine the progression of a proposed project. Compare different proposed projects, and place them in rank order of payback period. The payback period can be assessed against a cu-off period. For example some businesses would have a payback period of a maximum of 5 years, any longer and the project will not go ahead.

  8. The capital invested will always have an opportunity cost. A business may have borrowed the finance, the longer the payback the higher the total interest payments will be. Longer payback period is bad because… The longer the payback period, the more uncertain the whole investment becomes. Cash flows expected in the distant future have less value than immediate cash flows.

  9. Using the payback method is useful as it give quantifiable information about the potential success of a project. However it is not used in isolation from other investment appraisal methods. Average rate of return (ARR) Measures the annual profitability of an investment as a percentage of the initial investment. Add all positive cash flows (9,000,000) Minus cost of investment (9,000,000 – 5,000,000) Divide by life span (4,000,000 / 4) Calculate the % return (profit / initial investment) (1,000,000 / 5,000,000 X 100) 20% This means that the business will receive 20% of their initial investment / annum on average.

  10. H Discounting Using the payback period and the ARR jointly can lead to conflicting choices. Payback period ARR Project A 3 years 15% Project B 4 years 17% Would you like $1,000 today or next year? Money loses value over time. Therefore ‘discounting’ takes the time value of money in to consideration. Discounting is the process of reducing the value of future cash flow to give its real value in today’s terms.

  11. H Discounting Discounting tables are provided. See page 190

  12. H Payback, ARR and discounting techniques all provide the business with useful quantifiable information. However qualitative information is equally important but difficult to measure because it is often subjective. Localgovernment will only grant planning permission once there has been a thorough cost / benefit analysis. The investment will have to benefit the majority of stakeholders. An investment might lead to bad publicity and ultimately the business’ reputation. Business ethics. Should a retailer invest in a clothes factory in India, where there is a chance child labourers will be used. The quantifiable data says YES but morals say NO!

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