Unit 3.8: Investment Appraisal - IB Business Management

This video will go through the key concepts in Unit 3.8 Investment Appraisal. This is another important quantitative topic in Unit 3. This topic will look at the ways in which a business evaluates whether to make an investment or not. Now, when we think of investment, we think of a firm spending on non-current assets because of their belief that the investment will generate long-term profits for the business. In this topic, we will look at three different ways in which an organization can assess whether this investment is worth it from a quantitative point of view. The first is the payback period. This is an investment appraisal technique that looks at how long it will take for a firm to recoup its initial investment cost in a non-current asset. In other words, we're looking at how long does it take after the investment for the firm to earn enough profit to recover all of its initial costs. The payback period is a useful way to measure an investment if the firm cares about time in their investment decisions and wants a quick return on their investment. The payback period is also quick and easy to calculate. It is also easy to interpret, allowing for a time-based comparison of projects. However, it ignores the timing of net cash flows and ignores cash flows after the project is paid back, which could also impact profitability. So payback period doesn't really consider overall profitability. It only really cares about until the project pays back. There are two types of payback period questions that you can run into in this course. We classify them as the easy and the regular type. The easy type of payback period questions is where the annual cash flows are the same. And so here we have a simple formula to use where the payback period is equal to the cost of the investment divided by the annual net cash flow. Keep in mind this formula only works when the cash flows are the same each year. Do not use this formula when the cash flows are different each year. That is the more common type of question in tested school and on the final IB exam when the cash flows are different each year. The other type of payback period question, like I said, the different net cash flows each year. So one thing you need to make sure you do is to adjust your running cost as part of your net cash flow. So don't just take the number given to you in the case study. Make sure you look in other parts of the case study and check. Are there any other costs that I need to take into account? So, for example, a firm might buy a new oven. Now, there's the initial cost of buying a new oven. But every year there might be maintenance or insurance costs associated with the oven. You cannot ignore these costs, right? These costs reduce the profit that the firm earns on the on the oven each year. And you need to take these into account when doing these calculations. The second type of investment appraisal technique is the average rate of return. So the average rate of return or the ARR looks at the average annual profit of an investment. And this is expressed as a percentage of the initial amount invested. So the ARR can be calculated by the average annual profit divided by the initial investment. We recommend splitting out the forming up into what is shown on the screen here so that you can more easily plug in numbers from the case into the formula. And that decreases the chance that you make a mistake. You are given the ARR formula on your final exam, as well as if you have a finance test, your teacher should be giving you this formula as part of the formula sheet. The higher the ARR, the more financially attractive an investment project tends to be. So firms can compare this number, this ARR, against the ARR of other projects, as well as the interest rate, which represents how much they would get if they just left the money in the bank. So the advantage of the ARR is that it is simple and easy to calculate, and that it focuses on profitability rather than time when measuring returns. However, much like the payback period, it relies on predicted or forecasted figures, and it ignores the timing of the cash flows. For a more detailed walkthrough on how to calculate the payback period and ARR questions at all levels of difficulty given case information, check out the quantitative skills videos on our website, where we will also point out some common tricks that your teacher or the IB might throw at you in these questions, as well as how to comment on and interpret these figures, which have become more important in the current version of the BM syllabus. Also, another thing to remember with these investment appraisal questions, these concepts only consider the quantitative side of things. So payback period and average rate of return, they are quantitative decision-making tools. When deciding whether to invest in a project, you should consider both the quantitative aspect and the qualitative aspect, such as impacts on employees. A holistic analysis is always required when making investment decisions. So that concludes the key concepts for SL students. You can skip straight to the end. HL students, we have one more technique that we will go through called the net present value. The net present value is the difference between the present value of future net cash flows and the initial cost of investment. Now, that might sound confusing. The NPV is the most complicated one for most students. So let's break this concept down. And to do that, we're going to introduce a concept called the time value of money. And this basically means that $1 today is worth more than $1 you receive next year, which would be worth more than $1 you receive five years in the future. So the net present value is basically taking into account this fact that cash flows received today are more valuable to the business than cash flows received in the future. And the way they do this is by discounting these cash flows that the business receives in the future into how much they would be worth today, according to the business's own factors. And we call that the present value. So the rate that we use to discount these future cash flows is called the discount rate. The discount rate is influenced by the interest rate. If the interest rate is higher, the discount rate will be higher because the business will earn more by leaving their cash in the bank, basically doing nothing. And therefore, future cash flows need to be higher to justify investment today. As a simple example, if we had an investment that would cost us $100 and we would earn $105 next year, we might immediately think, yes, we should take that investment. The returns are positive. However, the NPV makes us consider the time value of money, the timing of the cash flows. If our discount rate was six percent, maybe because our firm could earn almost that amount by leaving it in the bank, the $105 would actually only be worth $99.05 to us today. And therefore, we should not take this investment. We're actually better off leaving our cash in the bank instead of investing. So the higher the interest rate, the lower the present value of future cash flows and the less likely we take the investment. And this, again, may still seem a little bit complicated to you, especially if you're learning this concept for the first time. So for a more detailed walkthrough on how to interpret and answer these NPV questions, check out the quantitative skills video on our website. Like I said, this is something that students do tend to struggle with, particularly the qualitative side of things. And it is worth doing extra practice as an HL student. This is more likely to show up in your paper to section eight. The big advantage of NPV is that it does consider the timing of the cash flows, unlike the payback period and average rate of return, and therefore is the most accurate form of investment appraisal. However, it can be difficult to determine an accurate discount rate and project net cash flows many years into the future. That concludes the key concepts for this topic. We recommend you use these steps as part of your study routine. Pay particular attention to steps two and three, as this is something overlooked by many BM students. Practicing case studies and developing application skills is the best way for you to improve your grade in BM, as all your school tests and the final exam are case study based. To practice these skills and access more detailed videos on BM content, please check out the resources on our website, diplomaly.org. If you need any support with any part of the BM course, including the IA or EE, feel free to get in touch with us via email or WhatsApp. Best of luck with your study!