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Planning effective growth - Investment appraisal:

Investment is a key part of building your business. New assets such as machinery can boost productivity, cut costs and give you a competitive edge. Investments in product development, research and development, expertise and new markets can open up exciting growth opportunities.

At the same time, you need to avoid overstretching limited financial resources or restricting your ability to pursue other options. Deciding where to focus your investment is an essential part of making the most of your potential.

Even a project that is not designed to generate a profit should be subjected to investment appraisal to identify the best way to achieve its aims.

This page highlights the key financial and non-financial factors you should take into account when considering an investment. It also introduces the main financial appraisal techniques you can use.

Financial aspects of investment appraisal

Different appraisal techniques let you assess the effects an investment will have on your cash flow. You can compare the expected return to the cost of funding and to the returns offered by other potential investments.

Your assessment should consider all the financial consequences of an investment. For example, buying more expensive machinery might be worthwhile if it is more efficient and uses cheaper supplies.

As well as the financial impact, your calculations should also consider any indirect effects. Identifying these soft benefits is often as important as the financial evaluation and may help your decision-making. Soft benefits could be:

• greater flexibility and quality of production
• faster time-to-market resulting in a bigger market share
• improved company image, better staff morale and job satisfaction, leading to greater productivity
• quicker decisions due to better availability of information

It is also important to evaluate these benefits. For example, a manufacturer of machine parts could take a general benefit such as quality and break it down with estimated savings:

• Reduced reworking means less disruption to the production process, less manufacturing down-time and fewer design changes, resulting in an overall saving of 25 per cent.
• The current warranty and service costs of £10,000 per annum are likely to be halved.
• Quality assurance staff will be reduced by one as needs for inspections are lower.
• Better quality products will increase sales by 6 per cent and will also improve the company's current position of fourth among its competitors.

It is also important to evaluate these benefits. It is important to estimate the benefits of the investment in financial terms wherever possible.

You should ignore any sunk costs (ie costs that have already been incurred and cannot be recovered or would be spent regardless of whether the investment goes ahead), as these are not part of the specific investment.

Investment appraisal techniques

Accounting rate of return

The accounting rate of return (ARR) is a way of comparing the profits you expect to make from an investment to the amount you need to invest.

The ARR is normally calculated as the average annual profit you expect over the life of an investment project, compared with the average amount of capital invested. For example, if a project requires an average investment of £100,000 and is expected to produce an average annual profit of £15,000, the ARR would be 15 per cent.

The higher the ARR, the more attractive the investment is. You can compare the ARR to your own target rate of return, and to the ARR on other potential investments.

The ARR is widely used to provide a rough guide to how attractive an investment is. The main advantage is that it is easy to understand.

Disadvantages

Unlike other methods of investment appraisal, the ARR is based on profits rather than cash flow. So it is affected by subjective, non-cash items such as the rate of depreciation you use to calculate profits.

The ARR also fails to take into account the timing of profits. In calculating ARR, a £100,000 profit five years away is given just as much weight as a £100,000 profit next year. In reality, you would prefer to get the profit sooner rather than later.

Payback period

Payback period is a simple technique for assessing an investment by the length of time it would take to repay it. It is usually the default technique for smaller businesses and focuses on cash flow, not profit.

For example, if a project requiring an investment of £100,000 is expected to provide annual cash flow of £25,000, the payback period would be four years. Similar calculations can be used to work out the payback period for a project with uneven annual cash flows.

Payback period is a widely used method of assessing an investment. It is easy to calculate and easy to understand. By focusing on projects which offer a quick payback, it helps you avoid giving too much weight to risky, long-term projections.

Disadvantages

Payback period ignores the value of any cash flows once the initial investment has been repaid. For example, two projects could both have a payback period of four years, but one might be expected to produce no further return after five years, while the other might continue generating cash indefinitely.

Although payback period focuses on relatively short-term cash flows, it fails to take into account the time-value of money. For example, a £100,000 investment that produced no cash flow until the fourth year - and then a payback of £100,000 - would have the same four-year payback period as an investment that produced an annual cash flow of £25,000. In reality, the first is likely to be a riskier and less attractive investment.

Discounting future cash flows

As a rule, money now is better than money in the future. There are two key reasons:

• Money has a time value. If you have money now, you can use it - for example, by putting it on deposit. Conversely, if you want money now but will only get it in the future, you would have to pay to borrow it.
• The further you look ahead, the greater the risks are. If you expect an investment to return £1,000 in a year's time, you may well be right. If you are looking ten years into the future, things might well have changed.

Discounting cash flow takes these concerns into account. It applies a discount rate to work out the present-day equivalent of a future cash flow.

For example, suppose that you expect to receive £100 in one year's time, and use a discount rate of 10 per cent. If you put £90.91 on deposit at 10 per cent for one year, at the end of the year you would have £100. In other words, the present value of that £100 can be calculated as £90.91.

Similar calculations can be used to work out the present value of cash flows you expect to receive further into the future. For example, suppose you expect to receive £100 in two years' time and use a discount rate of 10 per cent. If you put £82.64 on deposit for two years at 10 per cent, at the end of two years you would have £100. In other words, the present value of that £100 is £82.64.

Net present value and internal rate of return

Discounting cash flows allows you to put cash flows received at different times on a comparable basis. You can use discounted cash flows to evaluate potential investments. There are two types of discounting methods of appraisal - the net present value (NPV) and internal rate of return (IRR).

The NPV calculates the present value of all cashflow associated with an investment: the initial investment outflow and the future cashflow returns. The higher the NPV the better. For example, if an investment of £100,000 generates annual cashflow of £28,000 and you discount at 10 per cent, the NPV for five years of cashflow is £6,142. However, if the annual cashflow starts at £26,000 and goes up by £1,000 a year, giving the same total amount of cash over five years - £140,000 - the NPV, using a discount rate of 10 per cent, will be £5,422.

Alternatively, you can work out the discount rate that would give an investment an NPV of zero. This is called the IRR. The higher the IRR the better. You can compare the IRR to your own cost of capital, or the IRR on alternative projects.

The key advantage of NPV and IRR is that they take into account the time value of money – the fact that money you expect sooner is worth more to you than money you expect further in the future.

Disadvantages

NPV and IRR are sophisticated and relatively complicated ways of evaluating a potential investment. Most spreadsheet packages include functions that can calculate these or you could ask your accountant for help.

Investment risk and sensitivity analysis

A realistic assessment of risks is essential. In practice, the biggest risk for many investments is the disruption they can cause. For example, it can take longer than expected to implement new systems and train employees. The disruption can also lead to a loss of business.

Different outcomes

You need to be clear about your underlying assumptions and how reliable they are. If you are making a significant investment, it can be worth assessing the expected return using a range of different assumptions.

For example, you might look at what would happen if a key customer decided not to buy a new product you were developing.

If you cannot predict the future with confidence, you may prefer to choose a more flexible investment option. For example, you might prefer to get premises on a short-term licence rather than committing to a long-term lease or purchasing premises outright.

Rounded appraisal

Appraising an investment from several different angles can be the most effective way of deciding whether it is worth pursuing.

Techniques like payback period can be used as an initial screen: if an investment doesn't meet your payback target, you eliminate it.  If a project passes this first test, you can go on to use more complex calculations such as net present value. Crucially, you should also use your own judgement to consider non-financial factors and to think about how the investment fits your overall strategy.

Help with investment appraisal

Investment appraisal techniques rely on accurate calculations to come up with useable answers. Although some of these calculations can be complicated, modern spreadsheet software can help you process them.

For example, a typical spreadsheet package includes functions that can calculate net present value or internal rate of return.

Crucially, an effective appraisal relies on putting in the right figures. For example, the timing of cash flows can have a significant effect on how attractive an investment is. You may also need help dealing with more complex issues, such as the tax implications of different forms of financing.

You may want to ask your accountant for help and advice, particularly if large amounts of money are involved.