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3.3.2 Investment appraisal

A) Simple payback

Cash flows (£000s) Proposal 1 Proposal 2 Proposal 3 Proposal 4
Year 0 -£120 -£95 -£80 -£160
Year 1 £80 £10 £30 £30
Year 2 £40 £40 £40 £50
Year 3 £40 £40 £30 £90
Year 4 £20 £60 £30 £80
Year 5 £40 £50 £20 £60

Year 0 is the initial investment

Proposal 1 will be paid back in 2 years.

 

Proposal 2 costs £95

Year 3 £5 left to pay back

5(amount needed for investment to be paid back)/60 (year 4 return) x 12 (number of months in a year) = 0.9 rounded up = 1month. Total payback time = 3 years and 1 month  

 

Proposal 4

80/90 x 12 = 10.6 = 2 years and 11 months payback time

 

B) Average rate of return

Total net profit/number of years/initial cost x 100

 

Proposal 3

£70/5/80×100 = 17.5%

Proposal 4

18.75%

 

C) Discounted cash flow (net present value)

Cash flows (£000s) Proposal 1 Discount table 20% Present value
Year 0 -£120 1.00 -£120,000
Year 1 £80,000 0.80 64,000
Year 2 £40,000 0.64 25,600
Year 3 £40,000 0.51 20,400
Year 4 £20,000 0.41 8,200
Year 5 £40,000 0.33 13,200
Total 11,400

Makes up for the interest that could have been earned if the business put the money in a bank.

Times the each year of the proposal by the discount figure

If the net present value is positive then the project should go ahead.

 

E) Limitations of these techniques

  • Complicated – May be difficult for the user to make/understand.
  • Difficult to select most appropriate discount rate – If the rate is set too high then it may reduce the profitability of the project thus leading to the proposal being rejected.
  • NPV very sensitive to initial investment
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