Investment Appraisal

Capital investment Appraisal

Business expenditures for acquiring assets to be used for more than one year are called capital investments. Examples may include investment in properties, plant, equipment, vehicles, research and development projects and other non-current assets. The ultimate objective for making capital expenditure or investment is to improve or maintain the overall profitability and net worth of the enterprise over the long run.

The selection of long term projects or making capital investment decisions is one of the vital areas of long-term decision making. In an ideal world, organisations should go for all projects and prospects that add value to the business. However as businesses have limited financial resources so capital investment appraisal techniques are used to help in the selection of proper projects to yield optimum returns i.e. benefits from capital investment outweigh their costs.

The capital investment methods can be classified as discounting and non-discounting techniques. Discounting cash flow methods include Net Present Value and Internal Rate of Return whereas non-discounting methods include the Payback method and the Accounting Rate of Return (ARR).

Payback Period 

Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques. Accept the project only if it’s payback period is LESS than the target payback period.

Advantages

• Simple and easy to understand and calculate.
• Gives more importance on liquidity for making decision about the investment proposals.
• Payback period deals with risk. The project with a shortest PBP has less risk than with the project with longest PBP.

Disadvantages 

• Time value of money is not recognized.
• Payback period gives high emphasis on liquidity and ignores profitability.
• Only cash flow before the payback period is considered. Cash flow occurred after the PBP is not considered.

Accounting Rate of Return (ARR)

 Accounting rate of return is the ratio of estimated accounting profit of a project to the average investment made in the project. Average accounting profit is income expected to be earned during each year of the project's life time. Accept the project with highest ARR.

Accounting Rate of Return is calculated using the following formula:

Advantages

• It is easy to calculate and simple to understand.
• It recognizes the profitability factor of investment.
• Since ARR is based on accounting information other special reports is not required to determine it.

Disadvantages

• It ignores time value of money.
• It can be calculated in different ways. Thus there is problem of consistency.
• It ignores the cash flow from investment

Net Present Value (NPV)

Net present value (NPV) is a discounted technique where estimated cash flows must be converted into present value. NPV of a project is the potential change in an investor's wealth caused by that project while time value of money is being accounted for. It equals the present value of net cash inflows generated by a project less the initial investment on the project. It is one of the most reliable measures used in capital budgeting because it accounts for time value of money . In case of mutually exclusive projects (i.e. competing projects), accept the project with higher NPV.

Advantages

• Net present value accounts for time value of money which makes it a sounder approach than other investment appraisal techniques
• Cash flows before and after the life span of the project is considered.
• Profitability and risk of the projects are given high priority
• It helps in maximizing the firm’s value

Disadvantages

• Net present value does not take into account the size of the project therefore it cannot give accurate decision if the amount of investment of mutually exclusive projects is not equal.
• It is difficult to calculate the appropriate discount rate.
• It is difficult to use, calculate and understand.

Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. In other words, it is the discount rate which equates the present value of the future cash flows of an investment with the initial investment. A project should only be accepted if its IRR is NOT less than the target internal rate of return. When comparing two or more mutually exclusive projects, the project having highest value of IRR should be accepted.

IRR = A + ( B * C/D )

A = Rate of +ve NPV

B = Difference in Rate

C = +ve NPV

D = Difference between NPV

Advantages

• It considers the time value of money.
• It discloses the maximum rate of return the project can give.
• It considers and analyses all cash flows of entire project.
• It ascertains the exact rate of return the project.

Disadvantages 

• It is difficult to understand and calculate,
• Some complications due to trial and error method.
• It ignores economies of scale.