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SERVICES
EXPERIENCE
UNIT 13. INVESTMENT APPRAISAL
This is closely linked to feasibility analysis in that we have to screen the proposal using pre-determined criteria for profitability, liquidity and security. We look at the financial statements for the proposal and then look at the impact of this proposal on our total business. Some large projects are looked at in this way rather than just by themselves because they may have a significant impact, not only on the profitability for the whole business, but also on liquidity and security.
We may for instance appraise the investment using the normal profitability criteria and it gets a clean bill of health yet because of its size and funding requirements it might have a serious negative impact on our liquidity and security. When it comes to profitability criteria we tend to use the following techniques:
 | Contribution Break-even Point Net Margin Pay Back ROI Discounted Cash Flow |
Contribution
We have talked about the notion of "contribution" before. Contribution is a bit like gross profit. It is the residual of sales income minus variable costs. The percentage that contribution is of income should meet a predetermined standard. For example, if our contribution percentage on average is 30% what is the sense of investing in a project which promises only 10%?
Break-even Point
The break-even point is that point where fixed costs equal contribution and zero net profit is earned.
Once we have determined our fixed costs this automatically becomes our contribution target to break even. Using our contribution margin percentage we can calculate our break even sales level. We then compare this break even sales level with our budgeted sales level to calculate a break even point as a percentage of budgeted sales.
In some cases the margin of safety can be quite small. For example, our break even sales level might be 90% of budgeted sales. This means that if sales fall 10% against budget we are in a danger zone where we could start making losses. Conversely our break even point might be 60% of budgeted sales and in that situation we have a large comfort zone in the event that budgeted sales are not achieved before we start making losses.
We should look at each new project or profit generating proposal in this light as to what the percentage break even point is and compare this with a predetermined standard.
What is the good of filling up our business with a multitude of high break-even point activities?
Net Margin
Net margin we have already covered in our profitability ratio analysis and refers to the percentage that the project's net profit is of the total sales it would generate.
Pay Back
Pay back is a very simple yet popular tool for investment appraisal. It relates the flow of future earnings to the initial capital outlay.
To illustrate have a look at the following example:
|
Project A |
Project B |
Project C |
|
|
Capital outlay |
|
|
|
|
(inc. working capital) |
$10000 |
$10000 |
$10000 |
|
|
|
|
|
|
Net Earnings after Tax |
|
|
|
|
Year 1 |
1000 |
2000 |
500 |
|
2 |
2000 |
2000 |
500 |
|
3 |
3000 |
2000 |
1000 |
|
4 |
3000 |
2000 |
4000 |
|
5 |
2000 |
2000 |
3000 |
|
6 |
1000 |
2000 |
2000 |
|
7 |
- |
1000 |
2000 |
|
8 |
- |
1000 |
2000 |
|
9 |
- |
- |
2000 |
|
10 |
- |
- |
1000 |
It will take 4½ years for Project A to pay back the initial $10,000 capital outlay from projected net earnings. The overall conclusions are as follows:
Project A Pay Back Period 4½ years
Project B Pay Back Period 5 years
Project C Pay Back Period 5½ years
Which project would you choose? Obviously the one with the quickest pay back, all other things being equal.
Discounted Cash Flow
Using the notes in the section on discounted cash flow (see paragraph 3.13) try applying this theory to the figures for Projects A, B and C above. You will need to discount each of the yearly net profit flows. First of all look up the table on page 54 of the McMahon text and use the 10% figures and then have another go at it using the 8% figures. See how critical the choice of interest rate is.
We could introduce an additional investment appraisal tool at this point which relies upon discounted cash flow. It is called the "present value index". This is a useful tool where several projects are being assessed and we need a ratio to compare them because normally they will each have a different magnitude of sums involved.
For example, in the illustration above where the capital outlay was $100,000 we calculated the present value to be $96,661. When we compare this with the capital investment we can calculate a ratio of .96. This means that after allowing for the value of money at 10% we will not recover our original investment. If the present value were exactly $100,000 we would say that the project has an "internal rate of return" of 10%. Let us assume that we have calculated ratios for a series of projects using the present value index method.
Project A 1.04
Project B 1.12
Project C 1.27
Project D 1.31
Project E .89
Which one would you choose? First of all we would reject E and then our order of preference would be Project D, C, B, A.
Copyright © Bill Wright 1994