3-3-2-investment-appraisal

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An introduction to investment appraisal

Investment appraisal involves comparing the expected future cash flows of an investment with the initial outlay for that investment
A business may want to analyse:
- How soon the investment will recoup the initial outlay
- How profitable the investment will be
Before an investment can be appraised, key data will need to be collected, including:
- Sales forecasts
- Fixed and variable costs data
- Pricing information
- Borrowing costs

The collection and analysis of this data is likely to take some time
- It requires significant experience to interpret the data appropriately before the investment appraisal can take place
Different methods are used to appraise the value of an investment, including:
- The simple payback period
- The average rate of return (ARR)
- The net present value of the discounted cash flow

Simple payback period

The payback period is a calculation of the amount of time it is expected an investment will take to pay for itself
Where net cash flows are expected to be constant over time, the payback period can be calculated using the formula

$Payback space period space equals space fraction numerator Initial space outlay over denominator Net space cash space flow space per space period end fraction space equals space Years divided by Months$

Worked Example

Gomez Carpets is considering an investment in a new storage facility at a cost of £200,000. It expects an additional net cash flow of £30,000 per year as a result of the investment.

Calculate the payback period for the investment.

[3]

Step 1: Divide the initial outlay by the additional expected net cash flow

$equals space fraction numerator £ 200 comma 000 over denominator £ 30 comma 000 end fraction space space equals space 6.67 space years space space$ [1]

Step 2: Convert the outcome to years and months

6 years
0.67 years = 8.04 months [1]
Payback period = 6 years and 8 months [1]

Worked Example

Hammer and Son provides a household repairs service that has recently employed a new handywoman who requires her own van. The new van will be purchased for £32,000.

The net cash flows are expected to vary over the five years following its purchase and are shown in the table below.

Year	Net cash flow (£)	Cumulative cash flow (£)
0	(32,000)	(32,000)
1	14,000	(18,000)
2	10,000	(8,000)
3	6,000	(2,000)
4	3,000	1,000
5	2,000	3,000

Calculate the payback period for the van.

[4]

Step 1: Identify the final year where the cumulative cash flow is negative

In this case, the cumulative cash flow figure is -£2,000 at the end of Year 3
This is the remaining amount (outlay) outstanding [1]

Step 2: Calculate the monthly net cash flow for the next year

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Business_A-level_Edexcel

1-marketing-and-people

3-3-2-investment-appraisal

An introduction to investment appraisal

Simple payback period

Worked Example

Worked Example

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