Summary of "Investment Appraisal Explained"

Investment Appraisal Explained

The video Investment Appraisal Explained by Andrew Moer from Kaplan Financial provides a detailed overview of four main investment appraisal techniques used by companies to evaluate projects and maximize shareholder wealth. The session explains each method with examples, discusses their advantages and disadvantages, and highlights their practical applications in financial decision-making.

Main Financial Strategies and Business Trends Presented

Investment appraisal is used to decide which projects or investments will best maximize shareholder wealth. The video covers four key investment appraisal techniques:

Accounting Rate of Return (ARR)
Payback Period
Net Present Value (NPV)
Internal Rate of Return (IRR)

Methodologies and Step-by-Step Guides

1. Accounting Rate of Return (ARR)

Measures average annual profit before interest and tax (PBIT) as a percentage of investment.
Two ways to calculate the denominator (investment):
- Initial investment only.
- Average investment (average of initial cost and scrap value).

Formula: ARR = (Average Annual PBIT) / (Investment) × 100%

Example: Calculate average PBIT over project life, then divide by initial or average investment.

Advantages: - Simple and quick to calculate. - Uses the whole project life. - Relative measure (percentage) allows comparison of projects of different sizes.

Disadvantages: - Uses profits, which can be manipulated by accounting policies. - Ignores time value of money. - Percentage can be misleading without context of project scale.

2. Payback Period

Measures how long it takes to recover the initial investment from cash inflows.
Uses cumulative cash flows to find when net investment reaches zero.
Exact payback time can be calculated by interpolating partial years.

Advantages: - Simple and intuitive. - Uses cash flows (preferred over profits). - Links to liquidity (quicker payback preferred).

Disadvantages: - Ignores cash flows after the payback period. - Ignores time value of money (no discounting). - Does not provide a clear accept/reject decision.

3. Net Present Value (NPV)

Calculates the present value of all cash inflows minus present value of all cash outflows, discounted at the company’s cost of capital.

Decision rule: - Accept if NPV > 0 (project adds value). - Reject if NPV < 0. - NPV = 0 is break-even.

Example: Discount each year’s cash flow using discount factors (e.g., 10% cost of capital), then sum discounted inflows and outflows.

Advantages: - Absolute measure (monetary value of project’s contribution). - Considers entire project life. - Accounts for time value of money. - Clear accept/reject decision.

Disadvantages: - Requires estimation of cost of capital. - Sensitive to discount rate changes. - More complex to explain to non-financial stakeholders. - Relies on forecasts which may be uncertain.

4. Internal Rate of Return (IRR)

The discount rate at which NPV equals zero (break-even discount rate).
Can be calculated using software (e.g., Excel’s IRR function) or by interpolation between two NPVs.

Decision rule: - Accept if IRR > company’s cost of capital. - Reject if IRR < cost of capital.

Advantages: - Uses cash flows and considers entire project life. - Does not require pre-specified discount rate.

Disadvantages: - Can produce multiple or no IRR values with irregular cash flows. - Misleading name (not a direct rate of return). - Relative measure without indicating absolute value. - Best used alongside NPV rather than alone.

Key Takeaways

ARR and Payback are simpler but have significant limitations, especially ignoring the time value of money.
NPV is the most reliable and widely used method because it provides a clear monetary value and accounts for the time value of money.
IRR complements NPV by providing the break-even discount rate but should not be used alone.
Forecasting accuracy and cost of capital estimation are critical for reliable appraisal.
Understanding the strengths and weaknesses of each method helps in making informed investment decisions.

Presenter

Andrew Moer Tutor at Kaplan Financial

This summary captures the core financial strategies, detailed methodologies, and critical evaluations of investment appraisal techniques as explained in the video.