35 Investment appraisal

Need to know

There are three main methods of investment appraisal:

• 1Payback period
• 2Annual yield
• 3Discounted cash flow techniques.

Example

ABC Ltd has two competing investments, A and B, which both require £250,000 of initial investment and generate positive returns totalling £500,000 over the following five years. This equates to the same net return of £250,000 by the end of year 5.

The only difference between the investments is the timing of the returns within the five years. Investment A has constant returns of £100,000 per year, whereas investment B has escalating returns.

1 Payback period

The simplest form of ‘investment appraisal’ is the payback period (PBP). It measures the time required to pay back an investment.

In the above example of ABC Ltd, investment A ‘pays back’ during year 3 – i.e. by year 3, project A has generated £300,000 (£100,000 in each year). However, it takes project B until year 4 to pay back the cost of investment (£50,000 + £75,000 + £100,000 + £125,000).

The PBP provides a measure of risk. The longer the PBP, the higher the risk. Therefore, according to the PBP method, investment A is less risky than investment B, as it pays back quicker.

As well as using PBP to compare competing investments, some organisations set a target PBP for all investments.

By itself, the PBP is an incomplete method of investment appraisal. It does not give any indication of ‘return’ and it also does not consider the total life of an investment. For example, let us assume that investment A stops at the end of year 5 and investment B continues to generate returns in perpetuity growing at £25,000 per annum (£175,000 in year 6, £200,000 in year 7 etc.). PBP would, nevertheless, still choose investment A over investment B, as its sole criterion is the speed of payback.

PBP is therefore best used alongside the other methods of investment appraisal.

2 Annual yield (also known as ARR / accounting rate of return)

While there are several ways to calculate the annual yield, the simplest method is to divide the annual returns (net inflows) by the amount of the investment (capital outflows).

$\text{Annual yield \%}=\frac{\text{net annual inflow}}{\text{capital outflows}}\times 100$

For investments A and B, the annual yield can be calculated as follows:

Investment A’s annual yield is 40% each year, whereas investment B’s yield increases from 20% to 60% in line with the growth in its annual returns. Both investments have an average yield of 40% over their life. Investments A and B are therefore challenging to compare using the annual yield.

The annual yield calculation is synonymous with other internal and external performance measures such as return on investment (see Chapter 23 Profitability performance measures). This method of investment appraisal is therefore useful as it benchmarks potential investments against a company’s performance measures.

However, the annual yield by itself it is not an effective method of investment appraisal, mainly because it does not consider the timing of investment returns.

3 Discounted cash flows

Money today is worth more than money in the future. Accounting for the time value of money is important because there is an ‘opportunity cost’ of money (capital) being tied up in an investment. This ‘opportunity cost’ will depend upon the following factors, which can be unique to each business and its economic environment:

• ■interest paid if money is borrowed
• ■returns to shareholders if the investment is equity financed
• ■interest received on surplus funds if available
• ■the risk of the investment not performing as expected
• ■the risk of missing out on alternative opportunities
• ■inflation.

The most effective methods of investment appraisal account for the time value of money by discounting all future net cash inflows (and further capital outflows, if any) back to their equivalent present value (PV). The objective is to compare all cash flows from an investment on a like-for-like basis.

There are two ways to appraise investments using discounted cash flows (DCFs):

• aNet Present Value (NPV) – which focuses on values.
• aInternal Rate of Return (IRR) – which focuses on returns.

a NPV

The NPV represents the value or contribution of an investment for a business:

• ■If the NPV is positive, the investment is potentially worthwhile.
• ■If the NPV is negative, the investment is likely to make a loss.

See also ‘non-financial considerations’ under the In practice section below.

b IRR

The IRR represents the ‘rate of return’ of an investment. IRR uses DCFs to calculate a percentage return on investment. If an investment’s IRR is greater than an organisation’s cost of capital (see the Nice to know section below), then the investment is potentially worthwhile. If it is less, then the investment is likely to make a loss.

For investments A and B, the NPV and IRR are:

Investment A has a higher NPV and IRR than investment B and therefore should be ranked higher. The reason that A is ranked higher is simply because its cash returns arise earlier than investment B.

The calculation of NPV assumes a 10% opportunity cost of capital (see the Nice to know section below).

See also the Optional detail section below for a discussion of when NPV and IRR have different outcomes.

Why is this important?

Businesses face many competing investment opportunities. As capital is limited a business must rank and choose between these opportunities.

A prioritisation system is required to make the most profitable investment decisions. Ultimately there is a correlation between the success of a company and the success of its investments.

A financial cost versus benefit analysis using the above methods is an essential part of the decision-making process.

When is this important?

The timing of an investment can be critical to its success. Making an investment before competitors or waiting until the market is opportune can affect an investment’s outcome.

In practice

Any investment decision should focus not just on the returns but also on the risks.

PBP provides a partial assessment of risk – however, it is important to consider other risk factors when making an investment, such as:

• ■Will the product or service actually sell and be positively received by customers?
• ■Will competitors launch similar or better products?
• ■Will suppliers be able to deliver the required materials on time and at the right quality?
• ■How reliable is the forecast? For example, will the opportunity still be profitable if the sales price is 10% lower?
• ■If the investment fails, will there be a negative impact on the company’s brand?
• ■If the investment fails, will there be unforeseen costs, such as redundancy payments?
• ■Will the opportunity’s success or failure impact the organisation’s strategic goals?

The non-financial considerations of an investment, especially those involving customers and competitors can be just as important as financial considerations when making an investment decision. Many organisations require investment opportunities to be presented within a formal business plan which includes the non-financial and strategic benefits and costs.

Nice to know

Cost of capital

The cost of capital or the cost of financing an investment over the long term is one of the main costs of making an investment.

The cost of capital is essentially a weighted average cost of all the costs of a company’s sources of finance, made up of equity finance (see Chapter 29 Equity finance) and debt finance (see Chapter 30 Debt finance). This is known as the WACC (weighted average cost of capital).

Even if a company has raised finance specifically for an investment, it should still use its WACC. All investments should be treated as if they are financed out of a ‘pool’ of company finance.

The cost of capital is used to calculate a discount rate which in turn is used to calculate the present value of future cash flows in NPV calculations and to benchmark IRR calculations.

In practice some organisations will use a risk adjusted cost of capital to appraise non-core investments. This effectively provides an additional hurdle rate which investments must pass to be viable.

Optional detail

NPV versus IRR

Many organisations will calculate both the NPV and IRR of an investment. In practice, however, there are some organisations that place more reliance on the IRR as it gives a percentage outcome. This is easier to relate to and can be more conceptually benchmarked against other ‘returns’.

For the majority of investments, the NPV and IRR will provide the same assessment of an investment:

• ■a positive NPV usually means that the IRR is greater than the cost of capital and
• ■a negative NPV usually means that the IRR is less than the cost of capital.

However, from a purely mathematical perspective NPV is a superior measure. If it provides a different outcome to IRR, then NPV should be used instead. NPV and IRR may differ when:

• ■there are different sized competing investments
• ■an investment requires tranches of capital outflows during its life.

Reflect and embed your understanding

• 1Should organisations use several different methods to appraise each investment? If so, why?
• 2Rank the different investment appraisal techniques. Which are the best and why?
• 3Why should organisations consider risk as well as return, when appraising investment opportunities?
• 4Are non-financial considerations more, less or equally as important as financial considerations for investment opportunities?

For the authors’ reflections on these questions please go to financebook.co.uk

Where to spot in company accounts

The annual report for a listed company may include details of investment opportunities the business has undertaken or is planning to undertake.

A company may include its basis for making investment decisions for example, its hurdle rate, although it is unlikely to disclose specific details of each investment as this is sensitive information.

Extract from Greggs plc 2020 annual report and accounts

Greggs plc’s accounting policy note (Appendix p. 452) details Greggs plc’s approach to its impairment (see Chapter 18 Impairment) review.

The note says that the discount rate used for the impairment review ‘is based on the Group’s weighted average cost of capital (‘WACC’) with an uplift for risk in the current environment and at 2 January 2021 was 6.7% (28 December 2019: 5.4%)’.

This provides an indication of Greggs plc’s actual WACC, which will also be the basis for investment appraisal using discounted cash flows.

Consolidate and apply

To see how the concepts covered in this chapter have been applied within Greggs plc, review Chapter 36, p. 434.

Watch out for in practice

• →Is there a formal process for assessing investment opportunities?
• →Are multiple investment appraisal methods used when evaluating investment opportunities?
• →Is there an assessment of risk as well as the return from potential investments?
• →Are investment opportunities presented within a business plan which incorporates non-financial considerations?
• →Is the cost of capital regularly assessed?
• →Does the business accept or reject most projects? This may indicate its attitude to risk aversion or a too high/low hurdle rate.