The external factors when investing in a new machine for Cameron Balloons are:
Predicting the future costs and revenues will be difficult for Cameron Balloons and this possibly will be affected by some external factors.
The investment decision on return and why business should carry out investment appraisal
Businesses will make the decision of the investment by not just the return also the specification and the benefits the investment will create for the business. Businesses invest to remain competitive, build up capacity, and other facts which will have a positive affect on their business. In the case of Cameron Balloons they are planning to invest in a new machine to increase their capacity and maintain the productivity. They will consider these factors and finally look at the return then make their ultimate decision.
If a business decides to invest in various investment opportunities or if an investment is essential they will need to carry out an investment appraisal. Investment appraisal is a good technique to use for Cameron Balloons because they can find out the payback period, Accounting Rate of Return (ARR), Internal Rate of Return (IRR), and the Profitability Index.
Payback
Payback is the length of the time to repay the initial capital cost. For the payback it will be considered on the revenue the investment generates for example how much the machine costs, the price of the item it produces and how many units are produced annually. The payback period may be 2 years and it could also occur during a year. Cameron Balloons can take the account of this by dropping the cash inflows from the investment to days, weeks or years.
Below is the formula of payback
Days/Weeks/Months x Initial Investment
Payback = ------------------------------------------
Total Cash Received
By using the formula of payback Cameroon Balloons can have a suggestion about the machines which are planning to be invested in. The answer will show how long they have for the payback period and Cameron Balloons the can use other investment appraisal techniques to carry on with their investment scheme. The payback period will determine the shortest period of time to recover the initial cost and in this case Cameron Balloons will need to select the investment with shortest payback period.
The advantages of Payback Method:
- Easy and simple to apply
- Payback is useful when the technology is speedily altering
- If a business has cash flow problems payback method can be used because the project chosen will return cash to the company quicker than other ones.
The disadvantages of Payback method:
- All cash flows after the method is unnoticed which could lead to more profitable options being unnoticed if cash flows are very high for investments with longer payback periods
- Overall profitability of the invest project is ignored
- The timing of the cash flows within the payback period are unobserved
Machine 1 Payback Period:
36 x 40, 000 = 28.8
50, 000
Machine 2 Payback Period:
48 x 125,000 = 42.8
140,000
The calculations show that the machine 1 has a shorter payback period. In this situation Cameron Balloons should decide to invest in machine 1 because it has a shorter pay back period. The payback method looks at when the payback appears rather than the profit which the machine will make. The table shows that Cameron Balloons will have a sooner payback from machine 1 which is the most suitable to be invested in at this method.
Accounting Rate of Return (ARR)
This technique is used to show the outcome of the investment. It will compare the profit generated by the investment with the cost of investment. By using this method Cameron Balloons will identify whether the investment gives a worthwhile return or not.
The formula for ARR is:
Average annual return or annual profit
ARR = --------------------------------------------
Initial cost of investment
The advantages of ARR are:
- The technique concentrates on the profitability of the investment rather than the payback period. This is very useful because Cameron Balloons will want to know if the investment if profitable.
- It is simple to compare investment projects and higher the ARR better the project.
- This process could also be use to contrast the return on a certain project with the return on the capital employed in the whole business.
The disadvantages of ARR are:
- The scheme does not take into the account the timing of cash flows. This may be a problem if Cameron Balloons experience from poor or irregular cash flow.
- Ignores the time value of the money – this means what the money is worth now and what it will worth in the future.
- Average profit is used to calculate the ARR, this will mean that the business cannot determine the exact possibility of whether the investment project is profitable in early or late stages.
The ARR for Machine 1: 12.5%
The ARR for Machine 2: 4.8%
By looking at the table above the machine with the highest ARR is Machine 1 with 12.5 which mean that Machine 1 has a higher ARR and better to invest in. It also means Machine 1 is more profitable. This means that Cameron Balloons should decide to invest in Machine 1 which is more valuable for them because of its profitability.
Net Present Value
Net present value and discounting cash flows are used as a method of appraisal to evaluate the investment. The net present time value (NVP) contains the fact of ‘time value’ of the money. All of the money generated for the investment by investment for Cameron Balloons will be received in the future. If Cameron Balloons receive money in future it is worth less than the same amount of today because the money that Cameron Balloons have got today can earn interest if it is in bank. This means that the value of money is affected by interest rates. The NVP will Show Cameron Balloons what their investment would have earned them in an alternative investment system.
£ Now
£ In 5 years time
Which is worth more?
Future Value
PV = -----------------
(1 + i)n
Where i = interest rate
n = number of years
- The PV of £1 @ 10% in 1 years time is 0.9090
- If you invested 0.9090p today and the interest rate was 10% you would have £1 in a year’s time
- Process referred to as
The Advantages of Net Present Value
- Interest rates and timing in cash flows can be identified
- Effortlessly Comparing the returns from different investment options
- The opportunity cost of investment is taken into account. This means that the investment decision is based not simply on the net cash flows but on the interest ‘foregone’ by not depositing the money in the bank.
The Disadvantages of Net Present Value
- If a computer cannot be used then this method may be time consuming
- NVP does not provide an accurate means of comparison if the initial outlay on projects is significantly different.
- The future rate of interest is possibly to vary changeably (because the NVP is calculated by the interest rate). This makes comparison and calculation tremendously tricky and doubtful.
Net Present Value for Cameron Balloons
The above table has been calculated according the present interest rate which is 5.5% as stated on the website of Bank Of England. The table shows that the net income from Machine 1 is higher which means that it is more valuable to invest in machine 1. Cameron Balloons should make a decision on investing in Machine 1 which has a better present value with the figures of 17121.917 according to the calculations.
Return on Capital Employed Ratio ROCE
The Return on Capital Employed ratio (ROCE) explains the profit which a business earns from the investment that shareholders have made in the company and it is the ratio to measure the performance of the business. ROCE is the method to contrast the profit made by the business and the money invested in it. When calculating the ROCE the profit is considered as net profit or the operating profit before tax and interest. This is known as the earnings before tax and interest. The long-term capital employed contains shareholders’ funds plus any long-term loan capital. The calculation for ROCE is:
Profit before tax and interest
ROCE = x 100
Long-term capital employed
ROCE is expressed as a percentage and if the result is higher this means its better and the results will also differ between industries.
Cameron Balloons can use ROCE to evaluate the performance of their whole business, but ROCE can also be used to evaluate the performance of the investments. Cameron Balloons are planning to make acquisitions and they can use ROCE to assess the performance of target companies when making the decision on which one to invest in. Companies with higher ROCE are probably more expensive to invest in.
Advantages of ROCE
- handy method to evaluate the performance of the whole business
- relates the return on investment (profit) to the size of the investment (capital employed), which allows the business to contrast investments of different sizes
Disadvantages of ROCE
- not a good technique of appraising investment in capital expenditure because the profit made by the investment may not be identified
- ROCE is generally used to evaluate historic performances not present performances
- Comparisons may be damaged because of various measures of capital employed are used by businesses.
The ROCE for Cameron Balloons
Machine 1
25,000
X 100 = 62.5%
40,000
The ROCE for Machine 1 is 62.5%
Machine 2
30,000
X 100 = 24%
125, 000
The ROCE for Machine 2 is 24%
The ROCE calculation for both machines shows the results of 62.5% and 24% this means that machine 1 has a higher ROCE percentage and Cameron Balloons should choose to invest in Machine 1 at this stage. The higher the percentage the better it is to invest in. Cameron Balloons should decide to invest in machine 1 which is more beneficial and suitable for them in these circumstances.
Different methods of investment appraisal have lead to different decisions.
A business can benefit from variety investment opportunities, or they can decide to whether to invest or not invest at all. To invest a business need to come to a conclusion in their investment options. Different methods of investment appraisals show different costs which can be used to capital costs and expected net cash flows. Most of these investment appraisal methods look at the profitability of the investment projects. Cameron Balloons will use different investment techniques to look at the investment projects and evaluate them. Different investment appraisals will have different benefits to the business by given them some figures for future references. For example a payback period will show length of the time to repay the initial capital cost and the Net Present value will give figures on time value of the money. By comparing these figures from the investment appraisal methods Cameron Balloons will have a decision which would be most suitable for them. The methods will give precise costs and returns on different investment projects. For example if a business is interested on more on the payback rather than the net present value than they will make a decision according to the results they receive from the payback method, or if the business is interested in the present value of the money that they will receive then they may decide to ignore the payback method and make a decision according to the net present value technique.