10.3.4 Investment Appraisal Decisions

Introduction

Investment decisions are some of the most critical choices a business makes. They usually involve large sums of money, long-term commitment, and significant risk. The process of investment appraisal helps managers decide whether an investment project is financially viable and strategically suitable.

Once the calculations have been carried out using methods like payback period, average rate of return (ARR), and net present value (NPV), managers must interpret the results to make the final decision. However, numbers alone do not always tell the full story—qualitative factors also influence decisions.

Quantitative Results And Their Impact On Investment Decisions

Quantitative results are measurable, numerical outcomes of investment appraisal techniques. They are crucial because they:

1. Provide objectivity
   • Financial efficiency ratios, payback period, ARR, and NPV give concrete figures that can be compared across different projects.
   • This reduces reliance on intuition or guesswork.
2. Key Quantitative Measures
   • Payback Period (PBP): Shows how long it takes to recover the initial investment.
     • Shorter payback = quicker recovery of funds, less risk.
     • Example: If Project A pays back in 2 years while Project B takes 5 years, a risk-averse business may prefer Project A.
   • Average Rate of Return (ARR): Shows the average annual profit as a % of investment.
     • Higher ARR = better return relative to cost.
     • Useful when comparing profitability of multiple projects.
   • Net Present Value (NPV): Calculates the present value of future cash inflows minus the cost of the project.
     • Positive NPV = project is profitable.
     • Negative NPV = project destroys value.
3. Impact On Decisions
   • Acceptance or rejection of projects: Projects with negative NPVs are usually rejected.
   • Ranking investments: Businesses can compare multiple projects and select the one with the highest NPV or ARR.
   • Risk management: Managers can evaluate how sensitive results are to changes in interest rates, sales forecasts, or costs.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A Level Business Full Scale Course

Worked Example – Quantitative Evaluation

A company is considering two projects, each requiring an investment of ₨500 000.

• Project A:
  • Year 1 cash inflow: ₨200 000
  • Year 2: ₨200 000
  • Year 3: ₨200 000
  • Year 4: ₨200 000
• Project B:
  • Year 1 cash inflow: ₨100 000
  • Year 2: ₨200 000
  • Year 3: ₨300 000
  • Year 4: ₨200 000

Calculations:

1. Payback Period
   • Project A: Needs ₨500 000.
     • After Year 1: 200 000
     • After Year 2: 400 000
     • After Year 3: 600 000 (payback achieved between Year 2 and 3).
     • Remaining after Year 2 = 100 000.
     • In Year 3: 100 000 ÷ 200 000 = 0.5 years.
     • PBP = 2.5 years.
   • Project B: Needs ₨500 000.
     • After Year 1: 100 000
     • After Year 2: 300 000
     • After Year 3: 600 000 (payback achieved between Year 2 and 3).
     • Remaining after Year 2 = 200 000.
     • In Year 3: 200 000 ÷ 300 000 = 0.67 years.
     • PBP = 2.67 years.

   ⇒ Project A pays back slightly faster.

2. Average Rate of Return (ARR)
   • Average annual profit = (Total Net Cash Inflows ÷ Number of years) – (Annual Depreciation).
   • Suppose both projects have no residual value and life = 4 years. Annual depreciation = 500 000 ÷ 4 = 125 000.
   • Project A:
     • Total inflows = 200 000 + 200 000 + 200 000 + 200 000 = ₨800 000.
     • Average annual profit = (800 000 ÷ 4) – 125 000 = 200 000 – 125 000 = ₨75 000.
     • ARR = (75 000 ÷ 500 000) × 100 = 15%.
   • Project B:
     • Total inflows = 100 000 + 200 000 + 300 000 + 200 000 = ₨800 000.
     • Average annual profit = (800 000 ÷ 4) – 125 000 = ₨75 000.
     • ARR = 15%.

   ⇒ Both projects give the same average return.

3. Decision Impact
   • Based on payback, Project A is better (faster return).
   • Based on ARR, both are equal.
   • If risk is high and business wants quick recovery → choose Project A.
   • If considering long-term value and stability, either may be chosen, but further analysis (e.g., NPV) is needed.

Qualitative Factors And Their Impact On Investment Decisions

Numbers are useful, but they don’t capture everything. Qualitative factors include:

• Brand Image And Reputation
  • A project with a good financial return but negative social or environmental impact may damage the brand.
  • Example: A mining project in a forest may face public backlash despite being profitable.
• Impact On Employees
  • Will the project create or eliminate jobs?
  • Example: Relocating a factory overseas may save costs but damage employee morale and attract criticism.
• Impact On Customers
  • Will the investment improve customer satisfaction (e.g., better service, new products)?
  • Example: Launching a mobile app may not give immediate profit but can build customer loyalty.
• Long-Term Strategic Fit
  • The project must align with the firm’s long-term objectives.
  • Example: A company aiming to become environmentally sustainable may reject an investment in coal mining, even if financially profitable.
• Ethical And Social Responsibility Issues
  • Projects involving child labour, environmental damage, or health risks may face resistance from stakeholders.
  • Example: Shell has faced criticism for oil drilling in environmentally sensitive areas.
• Government And Legal Regulations
  • Legal restrictions, licensing requirements, and political risks must be considered.
  • Example: An alcohol company cannot invest in countries where alcohol is banned.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A Level Business Full Scale Course

Comparison Of Investment Appraisal Methods

1. Payback Period (PBP)
   • Strengths:
     • Simple to calculate and understand.
     • Emphasises liquidity — useful for businesses with cash flow problems.
     • Useful in industries with fast-changing technology.
   • Limitations:
     • Ignores cash flows after the payback period.
     • Ignores the time value of money.
     • Focuses only on speed of return, not total profitability.
2. Average Rate Of Return (ARR)
   • Strengths:
     • Considers total profit over the project’s life.
     • Expressed as a percentage, easy to compare with target return or interest rates.
   • Limitations:
     • Ignores the timing of cash flows.
     • Uses average profit, which may hide variations in yearly earnings.
     • Less useful in high-risk or uncertain environments.
3. Net Present Value (NPV)
   • Strengths:
     • Considers the time value of money (future cash inflows are worth less than present inflows).
     • Directly shows the expected addition to shareholder value.
     • Positive NPV projects should, in theory, increase shareholder wealth.
   • Limitations:
     • Requires accurate estimation of discount rate (cost of capital).
     • Results depend heavily on assumptions about future cash flows.
     • More complex to calculate than PBP or ARR.

Example – Comparing Investment Appraisal Methods

A business is considering two projects:

• Project X
  • Cost = ₨200 000
  • Cash inflows: Year 1 = 70 000, Year 2 = 80 000, Year 3 = 90 000
• Project Y
  • Cost = ₨200 000
  • Cash inflows: Year 1 = 100 000, Year 2 = 60 000, Year 3 = 70 000
• Residual value = 0
• Life = 3 years
• Discount rate = 10%

Step 1: Payback Period

• Project X:
  • Year 1 = 70 000
  • Year 2 = 150 000 (still less than 200 000)
  • Year 3 = 240 000 (surpasses 200 000 in Year 3)
  • At end of Year 2 = 150 000 recovered; need 50 000 more.
  • In Year 3, 90 000 received → 50 000 ÷ 90 000 = 0.56 years.
  • PBP ≈ 2.56 years.
• Project Y:
  • Year 1 = 100 000
  • Year 2 = 160 000 (still below 200 000)
  • Year 3 = 230 000 (surpasses 200 000 in Year 3).
  • Need 40 000 more after Year 2.
  • In Year 3, 70 000 received → 40 000 ÷ 70 000 = 0.57 years.
  • PBP ≈ 2.57 years.

Step 2: Average Rate Of Return (ARR)

• Project X:
  • Total inflows = 240 000.
  • Average annual profit = 80 000.
  • ARR = (80 000 ÷ 200 000) × 100 = 40%.
• Project Y:
  • Total inflows = 230 000.
  • Average annual profit = 76 667.
  • ARR = (76 667 ÷ 200 000) × 100 ≈ 38.3%.

Step 3: Net Present Value (NPV)

• Discount factors at 10%:
  • Year 1: 0.909, Year 2: 0.826, Year 3: 0.751
• Project X:
  • PV inflows = (70 000×0.909) + (80 000×0.826) + (90 000×0.751)
  • = 63 630 + 66 080 + 67 590 = 197 300
  • NPV = 197 300 – 200 000 = –2 700 (negative, not viable)
• Project Y:
  • PV inflows = (100 000×0.909) + (60 000×0.826) + (70 000×0.751)
  • = 90 900 + 49 560 + 52 570 = 193 030
  • NPV = 193 030 – 200 000 = –6 970 (negative, not viable)

Decision

• Based on PBP: Project A is slightly quicker.
• Based on ARR: Project A is better.
• Based on NPV: Both projects are not viable (negative returns).
• Managers must consider both financial ratios and qualitative factors before making the final choice.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A Level Business Full Scale Course

Limitations Of Investment Appraisal Methods

• Uncertainty Of Forecasts
  • Future sales, costs, and interest rates are unpredictable.
• Short-Term Bias
  • Payback ignores long-term profitability.
• Complexity
  • NPV calculations are complex and require discount rate estimation.
• Ignores Qualitative Factors
  • None of the methods consider social responsibility, employee welfare, or long-term strategic value.
• Conflicting Results
  • Different methods may give different results (e.g., PBP favours quick returns, NPV focuses on value added).
• Static Assumptions
  • They assume cash inflows are known and constant, but in reality they fluctuate.

Qualitative Factors Affecting Investment Decisions

• Brand Image And Reputation
  • Investment projects should not harm the company’s public image.
  • Example: Oil companies face resistance when drilling in environmentally sensitive areas.
• Impact On Employees
  • Investments may require redundancies or upskilling.
  • Example: A bank investing in ATMs may reduce cashier jobs but require more IT staff.
• Impact On Customers
  • Will the investment improve customer experience?
  • Example: Online banking services may not yield immediate profit but improve customer satisfaction.
• Legal And Environmental Issues
  • New projects must comply with laws and environmental regulations.
  • Example: A manufacturing company may avoid investing in regions with strict emission controls if compliance costs are too high.
• Ethical Considerations
  • Projects involving child labour or environmental harm may be rejected despite profitability.
• Strategic Fit
  • Does the project align with long-term corporate strategy?
  • Example: A company committed to sustainability may avoid investing in fossil fuel projects.

Combining Quantitative And Qualitative Factors

• Best investment decisions require both financial data and qualitative considerations.
• Managers should:
  • Use investment appraisal methods to assess financial viability.
  • Evaluate strategic, social, and environmental impacts.
  • Consider risk factors such as political instability or market changes.
  • Communicate decisions effectively to stakeholders.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A Level Business Full Scale Course

Case Studies

• Coca-Cola Expanding Into New Markets
  • Conducts detailed NPV analysis before opening bottling plants.
  • Considers cultural factors (e.g., different taste preferences in Japan vs. USA).
  • Demonstrates combination of quantitative (profit forecasts) and qualitative (cultural adaptation) analysis.
• Nokia’s Decline
  • Heavy investment in outdated Symbian OS looked profitable at the time, but ignoring market trends (shift to smartphones and apps) led to failure.
  • Shows the limitation of relying only on quantitative measures.
• Engro Fertilizers (Pakistan)
  • Conducted investment appraisal for expanding its production plants.
  • Considered both financial viability (payback & NPV) and external factors such as energy supply reliability and government subsidies.

Exam Focus

• Quantitative results
  • Be able to calculate and interpret PBP, ARR, and NPV.
  • Understand how positive/negative values affect decision-making.
• Qualitative factors
  • Culture, brand image, government policy, employee relations, environmental sustainability.
  • Be prepared to apply examples in context (local and international).
• Evaluation and comparison of methods
  • Payback = simple and good for liquidity but ignores long-term benefits.
  • ARR = shows profitability in percentage but ignores timing of cash flows.
  • NPV = most accurate, considers time value of money and shareholder wealth, but depends on discount rate assumptions.
  • In exams, explain why different methods may give different results and why managers must use a combination of methods plus qualitative judgement.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A Level Business Full Scale Course