Here’s the second question I had a go at…
a) Explain the use of Payback, NPV and IRR as investment appraisal techniques.
b) Explain two other points that would be considered when making a decision on whether to invest in a project.
a) When considering various options to meet a need, we have to compare the economics of each. By undertaking this comparison, we can see clearly which options are financially advantageous, i.e. we get a ‘better’ return on our initial investment.
Payback looks at the number of years taken to accrue profits equalling the original investment. For example, a new product line costing £800k in Year 1, but making £200k clear profit per year will have a payback period of 800/200 = 4 years. Payback is not so useful for long term investments, where the value of money can decrease over time, meaning in effect that after 4 years we have something less than our original investment.
Net Present Value takes this depreciation of money over time into account, and can be used to predict the current value of costs over a long time (decades). However, it relies on a particular interest rate (or discount factor) being applied, and is therefore only as reliable as the correct selection of the interest rate!
Internal Rate of Return is the point is the discount factor at which the investment cost and the future value of that investment are equal. In reality, several techniques should be used to ascertain the whole picture.
b) i) When deciding whether to invest a project, the company board will look at where the project ‘fits’ in their overall portfolio. They do this to ensure that the project tallies with the achievement of one or more strategic objectives.
ii) They may also review the ‘risk vs return’ of the project; if they have several risky projects on the go already, they may wish to feel more secure with some of their investment, to achieve a balance of risk. Each company will have a different view on this balance, known as their risk appetite.
They may also consider in-house/outsourcing of resources, as there could be capacity bottlenecks that restrict the progression of some projects. Outsourcing may be more risky, and in this sencse it falls under ii also.
Again – looks short but took 15mins of furious writing!