new products, markets and so on.
* Indirect - social and welfare facilities.
Even the projects that are unlikely to generate profits should be subjected to investment appraisal. This should help to identify the best way of achieving the project's aims. So investment appraisal may help to find the cheapest way to provide a new staff restaurant, even though such a project may be unlikely to earn profits for the company.
Investment appraisal methods:
One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised one of two ways: traditional methods and discounted cash flow techniques. Traditional methods include the Average Rate of Return (ARR) and the Payback method; discounted cash flow (DCF) methods use Net Present Value (NPV) and Internal Rate of Return techniques.
Traditional Methods
Payback:
This is literally the amount of time required for the cash inflows from a capital investment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period. Payback is often used as an initial screening method.
Payback period = Initial payment / Annual cash inflow
So, if ￡4 million is invested with the aim of earning ￡500 000 per year (net cash earnings), the payback period is calculated thus:
P = ￡4 000 000 / ￡500 000 = 8 years
This all looks fairly easy! But what if the project has more uneven cash inflows? Then we need to work out the payback period on the cumulative cash flow over the duration of the project as a whole.
Payback with uneven cash flows:
Of course, in the real world, investment projects by business organisations don't yield even cash flows. Have a look at the following project's cash flows (with an initial investment in year 0 of ￡4 000):
But, here we must face the real problem posed by payback: the time value of income flows.
Put simply, this issue relates to the sacrifice made as a result of having to wait to receive the funds. In economic terms, this is known as the opportunity cost. More on this point follows later.
So, because there is a time value constraint here, the payback method can become complicated. In this case, the earlier flow of revenue is a key factor. Also if post-payback revenues occur earlier in the lives of competing projects, that can be a decisive factor.
OK, so it's clear that the payback method is a bit of a blunt instrument. So why use it?
Arguments in favour of payback
Firstly, it is popular because of its simplicity. Research over the years has shown that UK firms favour it and perhaps this is understandable given how easy it is to calculate.
Secondly, in a business environment of rapid technological change, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential.
Thirdly, the investment climate in the UK in particular, demands that investors are rewarded with fast returns. Man
