TABLE 3 Years 1+ 2 + 3 + 4
In Year 5 amount needed to recoup investment in full
= £34,500 = £40,000 -£ £34,500 = £5,500
Months in Year 5 before investment fully recouped = £5,500 x 12 £18,000
Net cash flow over 5 year project
Total net cash flow (after pay back)
TABLE 4
Proposal A Cash Cost
1 2 3 4 5
Avg annual cash savings
Payback
£40,000 Savings 9,000 9,500
10,500 10,500 12,000
10,300 4 years
0.5 months
Payback is the most frequently applied technique, which is used to screen out projects that would take too long to recoup the initial investment. A more accurate method of investment appraisal would then be used.
Table 4 shows how to evaluate the above projects using payback as the selection criterion. The cash inflows and outflows for each are shown.
The payback period can be of some use in screening the three proposals. Proposal A seems to be better than Proposal C - the shorter payback period is clearly better. Proposal B can be excluded outright - its initial cost exceeds future cash savings, so it does not pay for itself. Therefore, with payback, Proposal A is accepted.
This method has several shortcomings that limit its usefulness. First, the method does not consider the earnings that continue after the payback period is reached. Proposal C, for instance, has a total savings of £52,500 in comparison to the £51,500 total earnings of Proposal A. The slightly shorter payback of Proposal A may mislead the manager who relies solely on the payback approach to evaluating investments. Also, keep in mind that we are ignoring the time value of money of the cash savings for
90
Proposal B Cash Cost
£40,000 Savings 5,000 5,000 6,000 6,000 7,000
5,800 Not achieved
Proposal C Cash Cost
£40,000 Savings (4,000) 9,000
13,000 16,500 18,000
10,500 4 years
4 months
each proposal when using this payback approach.
2. Average Annual Return
Due to unpredictable fluctuations in returns over the life of a project, average return is often used as a slightly more accurate measure in investment appraisal. The total return (net cash flow) is averaged over the duration of the project.
The average annual return can also be converted into a percentage in relation to the value of the initial
investment.
Both these figures can be used as a basis of
comparison for different investment proposals. The average annual return percentage should
initially be compared with the
business's cost of capital (explained in Discounted Cash Flow).
Example 1
Using the figures for Project A, which had an initial
investment of £40,000: Year 1
2 3 4 5
Net Cash Flow 9,000
10,500 10,500 12,000
(See table 5) Example 2
Using the figures for Project C with an initial investment of £40,000:
Year 1
2 3 4 5
Net Cash Flow (4,000)
13,000 16,500 18,000
(See table 6) 3. Net Present Value
Both Payback and Average return have a major drawback in that they ignore the 'time' factor, i.e. £1 received today is worth more than £1 received in one year’s time.
The Net Present Value is the net value of the future cash flows, i.e. the value of the future total cash value flow minus the initial capital investment.
The cost of capital is the sacrifice made by the business by investing in a project, this
9,000 9,500 considers:
• Comparison with returns from investing the capital in an alternative way e.g. in a bank
• Interest on debts incurred to raise the funds to finance the project
• The time value of money Discount factor tables
Discount factors are used to calculate the Present Value of predicted net cash flows. Table 7 shows a discount factor table, which is used to provide the relevant discount factor for specific rates of costs of capital.
Example
The discount factor used for a net cash flow after 5 years at a cost of capital of 6% would be 0.7473.
Therefore, a predicted net cash flow of £100 in 5 years time at 6% would have a Present Value of £100 x 0.7473 = £74.73.
Example
1. Apply the 10% discount factor to the following Project A figures to calculate the Present Value of the future cash flows.
2. Calculate the Net Present
TABLE 7 - Discount Factor Table Present value of £1 received after n years discounted at i%
i 123456789 10 n 1 0.9901 0.9804 0.9709 0.9615 0.9524 0.9434 0.9346 0.9259 0.9174 0.9091 2 0.9803 0.9612 0.9426 0.9246 0.9070 0.8900 0.8734 0.8573 0.8417 0.8264 3 0.9706 0.9423 0.9151 0.8890 0.8638 0.8396 0.8163 0.7938 0.7722 0.7513 4 0.9610 0.9238 0.8885 0.8548 0.8227 0.7921 0.7629 0.7350 0.7084 0.6830 5 0.9515 0.9057 0.8626 0.8219 0.7835 0.7473 0.7130 0.6806 0.6499 0.6209 6 0.9420 0.8880 0.8375 0.7903 0.7462 0.7050 0.6663 0.6302 0.5963 0.5645
i 111213 14 15 16 17 1819 20
n 1 0.9009 0.8929 0.8850 0.8772 0.8696 0.8621 0.8547 0.8475 0.8403 0.8333 2 0.8116 0.7972 0.7831 0.7695 0.7561 0.7432 0.7305 0.7182 0.7062 0.6944 3 0.7312 0.7118 0.6931 0.6750 0.6575 0.6407 0.6244 0.6086 0.5934 0.5787 4 0.6587 0.6355 0.6133 0.5921 0.5718 0.5523 0.5337 0.5158 0.4987 0.4823 5 0.5935 0.5674 0.5428 0.5194 0.4972 0.4761 0.4561 0.4371 0.4190 0.4019 6 0.5346 0.5066 0.4803 0.4556 0.4323 0.4104 0.3898 0.3704 0.3521 0.3349
= £46,000 = £52,500 -£ £40,000 = £12,500 = 3.6 months
TABLE 5 Average return
= Total Return = Years
£51,500 5
£40,000
= £10,300
Average return % = Average return = £10,300 x 100 = 25.75% Investment
TABLE 6 Average return
= Total Return = Years
£52,500 5
£40,000 = £10,500
Average return % = Average return = £10,500 x 100 = 26.25% Investment
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