What do you think these two words together

mean?

Discuss with a partner, share with your table, then

share with the class (2 minutes)
 • 3.8 Investment Appraisal (SL Part)
• Payback Period
• Average Rate of Return

What is This refers to a series of quantitative techniques

Investment to calculate the financial costs and benefits of an
Appraisal? investment decision.

https://www.tutor2u.net/business/reference/investm
ent-appraisal-revision-quiz
TUTOR2U could be very helpful.

In this context, investment refers to the purchase of a fixed asset with

potential to yield future financial benefits i.e. Ford purchasing of a new
factory.
This ties in with the concepts of CHANGE and CREATIVITY.
What qualitative vs quantitative factors might a business need to
consider before making this investment?

Please write first - then discuss with a partner.

It is worth noting that overall investment decisions may depend on;
Mission Statement (Growth vs being ethical) Risk (appetite for this)
State of the Economy, HRM (will investment lead to redundancies?)
Potential for natural disasters (offshoring in the Philippines)
 Formulae Sheet - Clarification

Payback is NOT on Formulae Sheet – Please use strategy

given in this PPT and in your notes to help you to revise.

Even though you get the formula for ARR, you still have to
practice this strategy
 .
The Payback Period is the amount of time needed for an
investment project to earn enough money to repay the initial cost
of the investment. e.g. to Break Even (when revenues = costs)

The answer is usually in years and months.

Key Fact - Ideally you want this payback period to be as short as

possible but for huge investments (such as building a bridge) this
may not be possible.

Key Words – Initial Investment, Net Cash Flows (each year),

Cumulative Cash Flow, pay back
Worked Example – Wembley Stadium.

If this project cost

$1bn and had
profits (net cash
flows) of $200m
each year, what
would the payback
period be?
Worked Example – Wembley Stadium.

If this project cost $1bn

and had profits (net cash
flows) of $200m each
year, what would the
payback period be?

Yes, the answer is simple

and would be 5 years

However, the IB would NEVER be so

kind! Therefore, we need to use a
different strategy to work this out.
 Worked Example – Chocolate Manufacturer.

Net Cash Flow

(excluding Capital
In the exam, you are usually given
Years Investment)
a scenario which is similar to this
along with a table which has net 1 £100 000
cash flows. You will be asked to
2 £150 000
work out the Payback period (in
years & months) 3 £175 000
4 £150 000
A quick calculation reveal these
are not perfect numbers
 Worked Example – Chocolate Manufacturer.

Therefore, to work this out, it is best to create a Payback Period Table.

Once you practice this, these are easy to do

Net Cash Cumulative Payback

Flow Cash Flow (Yes or
Years (NCF) (CCF) No?) Key Words.

0 (£500 000) (£500 000) No Net Cash Flow - How much

profit is made each year.
1 £100 000 (£400 000) No
Cumulative Cash Flow - is the
2 £150 000 (£250 000) No sum of the Net Cash Flows
throughout each year.
3 £175 000 (£75 000) No
4 £150 000 £75 000 Yes

So we can see it is between Years 3 and 4 is the payback period. However,

the IB wants us to be precise so we need to know how many months too.
 Worked Example – Chocolate Manufacturer.

So we know it is between 3 and 4 years to repay the initial

investment cost.

Net Cash Cumulative Payback

Flow (NCF) Cash Flow (Yes or
Years (CCF) No?)

3 £175 000 (£75 000) No

4 £150 000 £75 000 Yes

Answer is 3 years + £75 000 (CCF in current year as a positive number ) x 12

£150 000 (NCF in next year)

Answer is 3 years + (0.5 x 12)

3 years 6 months.
 Ameer/Elias Worked Example. Based on £500 000 initial cost.

Step 1. Add up the Net Cash Flow (the number of years before it gets to the
initial cost)

Step 2. Work out how far this is away from the initial cost

Step 3. ( Amount away from the initial cost ) x 12

Next Years Net Cash Flow

Step 4. The answer is Step 1 and Step 3 calculations

Net Cash Flow

1. £100 000 + £150 000 + £175
(excluding Capital
000 = £425 000 (3 years)
Years Investment)
2. £500 000 - £425 000 = £75 000
1 £100 000 3. ( £75 000) x 12 = 6 months
2 £150 000 £150 000
3 £175 000 4. 3 years and 6 months
 Student PRACTICE – Same CASE STUDY.

Net Cash Flow

(excluding Capital
Please answer this in months and
Years Investment)
years.
1 £170 000
Once you have completed this
2 £190 000
conclude this learning by writing
down what you think are the 3 £115 000
advantages and disadvantages
4 £150 000
of the payback method of
investment appraisal?
 Student Practice – Chocolate Manufacturer.

Net Cash Cumulative Payback

Flow (NCF) Cash Flow (Yes or Remember, we need
Years (CCF) No?) to work out precisely
when between years
0 (£500 000) (£500 000) No 3 and 4 when the
Payback Period is.
1 £170 000 (£330 000) No
2 £190 000 (£140 000) No 3 + 25000 x 12
150000
3 £115 000 (£25 000) No
4 £150 000 £125 000 Yes

So the actual Payback Period is 3 + (0.16 x 12) = 2

Payback Period is 3 years 2 months.

The average rate of return (ARR) measures
the annual profitability of an investment as a
percentage of the initial investment. (It can
also be called Annual Rate of Return)

Ideally you want this percentage to be as high

as possible. You need to consider issues such
as interest rates which could impact on your
returns.

Key Words – Initial Investment, Net Cash

Flows (each year), Lifespan of Project
 Worked Example – Car Manufacturer.

A car manufacturer purchases some new robotics for £2m. This will enable the
business to produce more cars and improve the quality of their finished products.

Anticipated Net Cash Flows are shown in the table below.

Net Cash Flow

(excluding Capital
In the exam, you are usually given Years Investment)
a scenario which is similar to this 1 £670 000
along with a table which has net
cash flows. You will be asked to 2 £770 000
work out the Average Rate of 3 £570 000
Return (as a percentage)
4 £700 000
5 £640 000
Step 1 - Work out the total returns (add up the net
cash not including year 0).

Step 2 - Use this number to complete the formula.

Years Net Cash Flow

ARR = (£3,350,000 - £2,000,000)/5 x 100
£2,000,000
0 (2 000 000)
1 £670 000
ARR = (£1,350)/5 £270,000 x 100
2 £770 000
£2,000,000
3 £570 000
ARR = 0.135 x 100 = 13.5% 4 £700 000
5 £640 000
Would investors be happy with this result?
Total Returns £3,350,000
What about in the result was 2% what would
investors think? Justify your response.
 Student PRACTICE – Same CASE STUDY.

Use the same case study and work

Net Cash Flow
out the ARR of this project. Please
answer this as a percentage, and
(excluding Capital
comment on what investors might Years Investment)
think of this result. 1 £170 000
Once you have completed this 2 £190 000
conclude this learning by writing 3 £115 000
down what you think are the
advantages and disadvantages of 4 £150 000
using the ARR method of investment
appraisal?
 Student PRACTICE – Same CASE STUDY – Answer.

Net Cash Flow

ARR = (£625,000 - £500,000) / 4 x100 Years

£500,000

(£31 250) x100 0 (500,000)

£500,000
1 £170 000
= 6.25% 2 £190 000
3 £115 000
This ARR is quite low and would be a worry if
interest rates started to rise. 4 £150 000
Total £625,000
Returns
Advantages and Disadvantages of ARR.
 IB Past Paper 2017
Note – Initial Capital Investment was $10,000

Using the information above, calculate the payback period and the
average rate of return (ARR) for the 3D printing project (show all your
working). 4 marks (Please ignore Table 2, discount factors we will look
at this when focussing on NPV!)
Very Important - There can be 10 mark responses for Investment
Appraisal. They usually go along the lines of

Using the results of your calculations and information in the case study,
discuss whether Firm A should invest in a factory B
 More Practice

a) Define Leasing
b) Calculate both the Payback period and ARR for Mark Allegro Leasing Co
c) Comment on whether or not you believe Mark should invest in these
power tools.
 Retrieval Practice - Quiz.

Explain what is Payback and

outline an
Define ‘Investment Appraisal’
advantage/disadvantage to
his method.

Explain what is the Average What qualitative factors

Rate of Return and outline an must businesses consider
advantage/disadvantage to his when ‘appraising’ an
method. investment.
 Answers

Payback is the amount of time it takes

for an investment project to cover its
initial costs.
Quantitative techniques used to calculate
Pros - easy to calculate, compare with
financial costs and benefits of an
other choices
investment decision
Cons - Ignores time value of money,
difficult to predict the future.

ARR calculates the average yearly profit on

an investment project expressed as a
percentage of the amount invested.
Mission Statement
State of Economy
Pros - easy to compare with other choices,
STEEPLE Factors
allows decisions to be made,
Stakeholder Impacts
Cons - Ignores time value of money, difficult
to predict the future.
SL - Calculate Payback and ARR for both machines (Answer on Slide 29)

Based on numeric and non numeric data, recommend which machine Organix should
invest in (10) (Produce an outline for this) Answer on Slide 46)
 The answers

Harvester - Payback period = 3 years and 8 months (7 is

also acceptable)
PickIT - Payback period = 3 years and 5 months (4 is also
acceptable)

Harvester - Annual Rate of Return (380 - 245) 135/5 =

27/245 x 100 = 11.02%
PickIT - Annual Rate of return 300 - 170 = 130/5 = 26/170 x
100= 15.29%
 • Net Present Value – HL part of Investment Appraisal.

When a business makes an investment, this usually refers to the purchase of

capital goods such as property and equipment.

NPV is most accurate as it uses the idea that money promised in the
future is worth less than the same money received today.

Net Present Value (NPV) is used to calculate today’s value of estimated

cash flows resulting from an investment.
 If you had the choice of
receiving $50,000 today or
$10,000 for each of the next 5
years what would you choose?
I am guessing most of you would choose
receiving $50,000 now!

Money promised in the future is worth

less than the same money received
today

Why is this statement true?

$50,000 can be spent now and you

can reap the benefits immediately.

$50,000 could be saved at the current

interest rate. This means the
$50,000 will be worth more to you in
the future.

Cash today is definite, in the future it

could be uncertain.
I am guessing most of you would choose
receiving $50,000 now!

Money promised in the future is worth

less than the same money received
today

Why is this statement true?

$50,000 can be spent now and you

can reap the benefits immediately.

$50,000 could be saved at the current

interest rate. This means the
$50,000 will be worth more to you in
the future.

Cash today is definite, in the future it

could be uncertain.
Money invested over time – Example of the benefits of investing money.
This is what would happen if that $50,000 was invested at an interest rate
of 10%. (This interest rate is high but is given to reflect the power of
saving over time)

Year Value of $50,000 This proves that in 5 years time the

investment as grown over $30,000
0 $50,000 (assuming interest rate remains the
1 $55,000 same).
2 $60,500
*Note – This is similar to why people
3 $66,500 invest in the stock market!!
4 $73,155
5 $80,471

HOWEVER – If it this is true

$50,000 today is worth $80,471 in 5

years time, it is also true that
$80,471 in 5 years time is worth
$50,000 today.
 Formulae Sheet.

∑ = THE SUM OF
 • Net Present Value – HL part of Investment Appraisal.

To work out the NPV we need to know the following;

1: The
initial 4: Present
2: Net Cash 3: Discount
Value.
cost of Flows (NCF) Factor.(DF) NFC * DF
the
project.
5: Total Present Value.
Sum of all Present Values.

Formula is
Total Present Value– initial cost of project = NPV.
 Example of NPV
• Initial outlay: AH LTD $3m to purchase a new factory
• Expected Net Cash Flow is $7m over 5 years.

Net Cash Flow for AH LTD Discount Factors

Year Net Cash Flow Year Discount

(excluding initial Factors (10%)
outlay) $m
1 0.91
1 0.5
2 0.83
2 1
3 0.75
3 1.5
4 0.68
4 2
5 0.62
5 2
 Please complete by hand
Year Net Cash flow Discount factors Present Values ($m)
(NCF) ($m) (DF) @ 10% (NCF x DF)

0 (3) 1.0 (3)

1
2
3
4
5
Total NPV

In this example Net Present Value is calculated by

Total Present Values ($ m) – Initial cost ($ m) =

This is/is not a worthwhile investment because…..

Please discuss pros and cons of this technique.
 Example of NPV
Year Net Cash flow Discount factors Present Values ($m)
(NCF) ($m) (DF) @ 10% (NCF x DF)

0 (3) 1.0 (3)

1 0.5 0.91 0.455
2 1.0 0.83 0.83
3 1.5 0.75 1.125
4 2.0 0.68 1.36
5 2.0 0.62 1.24
Total NPV 2.01

In this example Net Present Value is calculated by

Total Present Values ($5.01m) – Initial cost ($3m) = $2.01m.

● Therefore, we can say that this is a worthwhile project to undertake.

● Outline advantages and disadvantages of a business using NPV.
 Advantages and Disadvantages of NPV
Advantages Disadvantages
■ It reasonably complex to calculate
■ The rate of discount can be and to explain.
varied to allow for different
economic circumstances. ■ The final results depends heavily
on the rate of discount used and
expectations about interest rates
■ It considers the time value of
may be inaccurate.
money and takes opportunity
costs into account.
Using information from Table 1 and Table 2, calculate the Net Present Value
for the printing souvenirs project. (4)
HL - Calculate NPV for both machines (4)
SL - Calculate Payback and ARR for both machines (8)

Based on numeric and non numeric data, recommend which machine Organix should
invest in (10)
 3 years and 4 months

Harvester - Annual Rate of Return (380 - 245) 135/5 = 27/245 x 100 = 11.02%
PickIT Annual Rate of return 300 - 170 = 130/5 = 26/170 x 100= 15.29%
10 Mark Advice - Suggested Structure (6 paragraphs)
d) Based on numeric
1 - Explain any BM terminology in the Q and the context of the case study. and non numeric data,
discuss whether KGL
2. - Firstly, … Point (ie. your first positive argument)
should invest in this
Explain, using relevant BM theory/tools/techniques.
Evidence to the case study. new machinery. (10)
This means that/as a result… Mention any implications of the point you made.

3. Secondly, … Point (ie. your second positive argument)

Explain, using relevant BM theory/tools/techniques.
Evidence to the case study.
This means that/as a result… Mention any implications of the point you made.

4. On the other hand … Point (ie.a negative argument in relation to the your points of view)
Explain, using relevant BM theory/tools/techniques.
Evidence to the case study.
This means that/as a result… Mention any implications of the point you made.

5. In addition,… Point (ie. another negative argument in relation to your points of view)
Explain, using relevant BM theory/tools/techniques.
Evidence to the case study.
This means that/as a result… Mention any implications of the point you made.

6. In conclusion,… State your conclusion (1 sentence). Justify it (2 sentence to give the major reason for
your judgement. (Weigh up why one point of view is more applicable than the other) Do not go through all
the arguments again.