Quantitative skills

Investment Appraisal

Payback (years and months)

Method

With the payback method, the project option that returns the initial cost of the investment in the
shortest timeframe is chosen. For example, if Project A costs £50 000 and generates cash flow of
£10 000 per year then it is clear that it takes 5 years to pay back. If Project B costs £35 000 and
generates £10 000 per year, then it will take 3 years and 6 months to pay back. Therefore, Project B
should be chosen because the payback period is shorter.
You need to be able to calculate the payback period in years and months (e.g. with Project B above).
Let’s consider an example:

A business is comparing two alternative investment projects. Project 1, an investment in new machinery
costs £90 000, or Project 2, the purchase of a retail outlet at a cost of £110 000. The expected Net Cash
Flows (NCFs) for each are:

Project 1 Project 2
Cost £90 000 Cost £110 000

Year 1 £20 000 £10 000

Year 2 £30 000 £20 000

Year 3 £40 000 £40 000

Year 4 £20 000 £60 000

Year 5 £20 000 £50 000

The steps to calculate the payback period are:

1) Add a cumulative (collective) cash flow column so that the cash flows each year are added together

Project 1 Cumulative Project 2 Cumulative

Cost £90 000 Cash Flow Cost £110 000 Cash Flow

Year 1 £20 000 £20 000 £10 000 £10 000

Year 2 £30 000 £50 000 £20 000 £30 000

Year 3 £40 000 £90 000 £40 000 £70 000

Year 4 £20 000 £110 000 £60 000 £130 000

Year 5 £20 000 £130 000 £50 000 £180 000

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Investment Appraisal
2) Establish whether any of the cumulative cash flows are equal to the project cost.

If this is the case, then the year in which the cumulative cash flow is equal to the Project Cost is the
payback period.

We can see that for Project 1 the £90 000 cost equals the Cumulative Cash Flow at the end of Year 3,
so Project 1 has a payback period of 3 years. This is where the calculation ends for Project 1, since the
payback period has been calculated.

3) If the Project Cost falls between two cumulative cash flows, as with Project 2, this indicates that the
payback period is part way between two years. In this case, the following steps are needed:

Project 2 Cumulative
Cost £110 000 Cash Flow

Year 1 £10 000 £10 000

Year 2 £20 000 £30 000

Year 3 £40 000 £70 000

Year 4 £60 000 £130 000

Year 5 £50 000 £180 000

3a) Find the 2 years that payback falls between

• For Project 2, this is between Year 3 (£70 000) and Year 4 (£130 000) since the project cost is
£110 000 and therefore falls between Year 3 and Year 4.

3b) Take the cumulative cash flow figure for the earlier year of these 2 years, and take it away from the
project cost.

For Project 2, Year 3 is the earlier year with £70 000 cumulative cash flow, which is taken away from the
project cost of £110 000

£110 000 – £70 000 = £40 000

The figure remaining (£40 000 in this example) is the balance of the project cost that is left to pay off in
the next year (i.e. part way through Year 4, in this example).

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Investment Appraisal
3c) Calculate the monthly cash flow for the upper year by dividing the cash flow for the year by 12.

• For Project 2, the upper year is Year 4 with a cash flow of £60 000, which when divided by 12
is £5 000 (per month)

3d) Divide the answer in 3b) (balance remaining by the answer in 3c) (monthly cash flow) to find the
number of months into the year it will take to payback the remaining project cost

• For Project 2, this is £40 000 / £5 000 = 8 months

3e) Add the answer to 3d (months) to the earlier of the two years that the payback fell between. That’s
it – you now have the answer!

• For Project 2, this is 3 years and 8 months

N.B. Step 3 (3a-3e) are only needed if a cumulative cash flow for a project does not equal the project
cost.

Therefore, in terms of payback period alone, Project 1 should be chosen as it has the shortest
payback period (3 years) compared to Project 2 (3 years and 8 months).

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Quantitative skills
Investment Appraisal
Example 1

A business is choosing to invest in one of the following two projects. The net cash flows are given for
each project.

  Fruit Press Bottling Plant

End of Year 1 £15 000 £5 000

End of Year 2 £15 000 £5 000

End of Year 3 £15 000 £20 000

End of Year 4 £15 000 £20 000

End of Year 5 £15 000 £40 000

The cost of each project is £40 000.

A) Calculate the payback period for each of the projects in years and months.

B) Which project should be chosen according to the payback period?

Answer:

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Quantitative skills
Investment Appraisal
Example 2

A business is considering purchasing either a new lorry or upgrading its warehouse.

The cost of the new lorry is £45 000 and the cost of upgrading the warehouse is £40 000.

The estimated annual returns for each project are provided in the table below

Year Estimated Annual Returns

  New Lorry Upgrading the Warehouse

1 £15 000 £20 000

2 £15 000 £20 000

3 £20 000 £15 000

4 £20 000 £10 000

5 £25 000 £10 000

A) Calculate the payback period in years and month for each project.

B) Which project should be chosen on the basis of the payback calculation?

Answer:

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Quantitative skills
Investment Appraisal
Example 3

A business selling collectable ornaments is considering investing in new machinery costing £60 000.
The estimated net cash flows for the first 6 years are provided in the table below:

Year Net Cash Flow (£000)

1 10
2 10
3 15
4 15
5 20
6 25

Use the information above to calculate the payback period in years and months if the business bought
the new machinery.

Answer:

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Investment Appraisal
Example 4

A business manufacturing candles wants to update their production equipment to achieve higher
productivity levels. There are two options, from which they must choose one given current budget
constraints: 1) The Wax Wonder and 2) The Wicked Wick Machine. The machinery will be replaced after
4 years due to anticipated wear and tear.

The estimated net cash flows and the cost for each of the machines is provided in the table below

  Net Cash Flows

The Wax The Wicked Wick

 
Wonder Machine

Cost £150 000 £200 000

Year    

1 £60 000 £60 000

2 £60 000 £60 000

3 £60 000 £60 000

4 £60 000 £60 000

A) Use the information above to calculate the payback period in years and months for each
machine

B) Which machine should be purchased on the basis of the payback calculation?

Answer:

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Investment Appraisal
Average Rate of Return (ARR)

Method

Using the ARR method is the average annual percentage return the investment provides to the
business. The project that has the highest average rate of return is chosen. For example, if the ARR
for Project A was 15% and for Project B was 20%, then Project B would be chosen because the ARR
percentage is higher than Project A.

Let’s use the same figures that were used for the payback example above.

Project 1 Project 2

Cost £90 000 Cost £110 000

Year 1 £20 000 £10 000

Year 2 £30 000 £20 000

Year 3 £40 000 £40 000

Year 4 £20 000 £60 000

Year 5 £20 000 £50 000

The steps to calculate ARR are:

1) Total the net cash flows for the life of each project (including any scrap or residual value of the
assets at the end of its useful life).

• Project 1 Total cash flows are £130 000

• Project 2 Total cash flows are £180 000

2) Deduct the project cost from the total net cash flow

• Project 1 £130 000 - £90 000 = £40 000

• Project 2 £180 000 - £110 000 = £70 000

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Investment Appraisal
3) Divide the answer in Step 2 by the number of years the project is expected to last to find out
the average net cash show per annum

• Project 1 £40 000 / 5 years = £8 000 per year

• Project 2 £70 000 / 5 years = £14 000 per year

4) Divide the answer in Step 3 by the project cost and multiply the answer by 100 to give a
percentage (this is the ARR).

• Project 1 (£8 000 / £90 000) x 100 = 8.89%

• Project 2 (£14 000 / £110 000) x 100 = 12.73%

Therefore, Project 2 should be chosen on the basis of the ARR calculation because the percentage
return is higher compared to Project 1.

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Investment Appraisal
Example 5

A business selling collectable ornaments is considering investing in new machinery costing £60 000.
The estimated net cash flows for the first 6 years are provided in the table below:

Year Net Cash Flow (£000)

1 10

2 10

3 15

4 15

5 20

6 25

Use the information above to calculate the average rate of return (to 2.d.p.) if the business bought the
new machinery.

Answer:

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Quantitative skills
Investment Appraisal
Example 6

A business manufacturing candles wants to update their production equipment to achieve higher
productivity levels. There are two options, from which they must choose one given current budget
constraints: 1) The Wax Wonder and 2) The Wicked Wick Machine. The machinery will be replaced after
4 years due to anticipated wear and tear.

The estimated net cash flows and the cost for each of the machines is provided in the table below

  Net Cash Flows

The Wax The Wicked Wick

 
Wonder Machine

Cost £150 000 £200 000

Year    

1 £60 000 £60 000

2 £60 000 £60 000

3 £60 000 £60 000

4 £60 000 £60 000

A) Use the information above to calculate the average rate of return for each machine

B) Which machine should be purchased on the basis of the average rate of return calculation?

Answer:

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Quantitative skills
Investment Appraisal
Example 7

A business is choosing to invest in one of the following two projects. The net cash flows are given for
each project.

  Fruit Press Bottling Plant

End of Year 1 £15 000 £5 000

End of Year 2 £15 000 £5 000

End of Year 3 £15 000 £20 000

End of Year 4 £15 000 £20 000

End of Year 5 £15 000 £40 000

The cost of each project is £40 000.

A) Calculate the average rate of return for each of the projects

B) Which project should be chosen according to the average rate of return calculation?

Answer:

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Quantitative skills
Investment Appraisal
Discounted Cash Flow (DCF) / Net Present Value (NPV)

Method

The Discounted Cash Flow method of investment appraisal takes into account the time value of money
(i.e. the realisation that the value of money changes over time). Using the DCF method of investment
appraisal, the project that has the highest ‘discounted cash flow’ is chosen (i.e. the return achieved
after net cash flows have been adjusted for the effects of changing value of money over time).

Again, let’s use the same figures as in the examples above:

Project 1 Project 2
 
Cost £90 000 Cost £110 000

Year 1 £20 000 £10 000

Year 2 £30 000 £20 000

Year 3 £40 000 £40 000

Year 4 £20 000 £60 000

Year 5 £20 000 £50 000

The steps to calculate DCF / NPV are:

1) Apply the ‘discount factor’ to the annual cash flows. You will be provided with the information you
need to apply the discount factor to the cash flows.

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Investment Appraisal
Let’s say that the discount factor given is 5%. The discount rates for a discount factor of 5% are provided
in the table below (remember, you will be given this information, you do not need to calculate the
discount factor or the discount rates):

Year Discount Rate (5% Discount Factor)

Year 1 0.952

Year 2 0.907

Year 3 0.864

Year 4 0.823

Year 5 0.784

To calculate the discounted cash flow for each year, multiply the discount rate for each year by the cash
flow for the same year. This is shown in the table below (columns have been added for the discount
rate and the discounted cash flow for each project).

Discount
Rate (5% Discounted Discounted Cash
Project 1 Project 2
Discount Cash Flow Flow
 
Factor)

  Cost £90 000   Cost £110 000  

Year 1 0.952 £20 000 £19 040 £10 000 £9 520

Year 2 0.907 £30 000 £27 210 £20 000 £18 140

Year 3 0.864 £40 000 £34 560 £40 000 £34 560

Year 4 0.823 £20 000 £16 460 £60 000 £49 380

Year 5 0.784 £20 000 £15 680 £50 000 £39 200

If there was any scrap value of the assets at the end of the project, this will be discounted by the same
rate used for the final year of the project. There is no scrap value in this example.

2) Add up the discounted cash flows for each of the projects.

This is shown by the addition of a total column to the table above

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Investment Appraisal

Discount Rate (5% Discounted Discounted Cash

Project 1 Project 2
Discount Factor) Cash Flow Flow
 

Cost Cost
     
£90 000 £110 000

Year 1 0.952 £20 000 £19 040 £10 000 £9 520

Year 2 0.907 £30 000 £27 210 £20 000 £18 140

Year 3 0.864 £40 000 £34 560 £40 000 £34 560

Year 4 0.823 £20 000 £16 460 £60 000 £49 380

Year 5 0.784 £20 000 £15 680 £50 000 £39 200

£112 950 £150 800

3) Deduct the project cost from the total discounted cash flow for each of the projects. This will give the
discounted cash flow (the final answer!).

• Project 1 £112 950 – £90 000 = £22 950

• Project 2 £150 800 – £110 000 = £37 850

Therefore, Project 2 should be chosen on the basis on the DCF calculation because it is the higher
figure compared to Project 1.

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Investment Appraisal
Example 8

A business is choosing to invest in one of the following two projects. The net cash flows are given for
each project in table 1. The present value of future cash flows is provided in table 2, using a discount
factor of 10%.

Table 1

  Fruit Press Bottling Plant

End of Year 1 £15 000 £5 000

End of Year 2 £15 000 £5 000

End of Year 3 £15 000 £20 000

End of Year 4 £15 000 £20 000

End of Year 5 £15 000 £40 000

Table 2

Year Present Value of Income at 10%

1 £0.91

2 £0.83

3 £0.75

4 £0.68

5 £0.62

A) Calculate the net present value for each project

B) Which project should be chosen on the basis of the discounted cash flow calculation?

Answer:

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Quantitative skills
Investment Appraisal
Example 9

A business is considering purchasing either a new lorry or upgrading its warehouse.

The cost of the new lorry is £45 000 and the cost of upgrading the warehouse is £40 000.

The estimated annual returns for each project are provided in table 1 and the present value of income
at 5% is shown in table 2.

Table 1

Year Estimated Annual Returns

  New Lorry Upgrading the Warehouse

1 £15 000 £20 000

2 £15 000 £20 000

3 £20 000 £15 000

4 £20 000 £10 000

5 £25 000 £10 000

Table 2

Year Present Value of Income at 5%

1 £0.95
2 £0.90
3 £0.86
4 £0.82
5 £0.78

A) Calculate the net present value for each project.

B) Which project should be chosen on the basis of the net present value calculation?

Answer:

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Quantitative skills
Investment Appraisal
Example 10

A business selling collectable ornaments is considering investing in new machinery costing £60 000.
The estimated net cash flows for the first 6 years are provided in the table below:

Year Net Cash Flow

1 £10 000

2 £10 000

3 £15 000

4 £15 000

5 £20 000

6 £25 000

The discount rate (based on a 10% discount factor) is given for each of the years the machine will be
used for in the table below:

Year Discount Rate (10% Discount Factor)

Year 1 0.91

Year 2 0.83

Year 3 0.75

Year 4 0.68

Year 5 0.62

Year 6 0.56

Calculate the net present value using the information above if the machine was to be purchased. Give
your answer

Answer:

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Investment Appraisal

Answers
Example 5
Example 1
9.72%
A)

Fruit Press 2 years 8 months

Bottling Plant 3 years 6 months Example 6

B)
A)
Fruit press
The Wax Wonder 15%

The Wicked Wick Machine 5%

B)
Example 2
The Wax Wonder
A)

New lorry 2 years 9 months

Upgrading the warehouse 2 years 0 months Example 7

B)
A)
Upgrading the warehouse
Fruit Press 18%

Bottling Plant 25%

B)
Example 3
Bottling Plant
4 years 6 months

Example 8
Example 4
A)
A)
Fruit Press: £16 850
The Wax Wonder 2 years 6 months
Bottling Plant: £22 100
The Wicked Wick Machine 3 years 4 months
B)
B)
Bottling Plant
The Wax Wonder

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Quantitative skills
Investment Appraisal
Example 9

A)

New lorry £35 850

Upgrading the warehouse £25 900

B)

New lorry

Example 10

£5 250

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