Investment appraisal methods are those, which are used by the organization to assess the importance of certain projects which are by nature capital intensive and which therefore need careful planning with regards to expenditure.
Where a huge amount of money is to be spending on a project, there is a need to assess the importance of such a project to the business and if it is not important then there alternative should be sought and money saved.
There are a number of techniques to assessing the project's viability including (Peter S., Deryl N., 2007);
Pay back method: which considers the period it takes for a project to pay for itself
Net Present Value method: this method considers the future value of money and brings this to its current value. For instance, it may seek to know how much £30000 to be earned in 4 years would be worth today.
Accounting Rate of return which considers the profitability of the project in assessing its worth basing on the returns to the capital that was invested.
Internal Rate of return: which considers the performance of the investment in terms of its expected rate of returns that neither leads to not profit nor loss.
As stated earlier, the decision to invest is not a light one and must be approached carefully. After identifying what needs to be bought, the management must then consider how much it would cost and the value that the investment would bring to the company.
By appraising the investments therefore, the organization is in a position to (Mott G., 2005)
Understand whether the investment is adding profit or performance to the organization. This will then be used to gauge whether the current performance with the new investment is better than the past performance. By using this measure the organization can tell if by investing it will be able to make profit or losses in the future, this is very important in understanding the future variable that may affect profitability.
Investments are likely to improve productivity through quick operations and reduce costs. This can be achieved by reducing the number of employees working since the new investment is now able to replace them; therefore costs are saved which can be used for further expansion
Investment appraisal may also provide an insight to the management of the viability of an investment in such a way that if it has been found to be of no benefit to the company then the organization may decide to sell it off and use the money to invest in another project. Therefore, through appraisal, the worth of the project can be identified. This is more important if the investment turns out to be a cash-draining item. Through appraisal, the management may be able to identify those investments that are useless and dispose them off
Through appraisal also, the management will be able to understand the right kind of investment and hence be able to invest appropriately, this will result in money being committed in the right ventures and hence good for the future of the organization.
However, by stating that investment appraisal adds value to the business organization is an overstatement, this is because (Glen A., 2006);
Investment appraisal is a management tool that can or may not be used by the management when evaluating an investment or evaluating to invest. The decisions of the management can hence be said to have a value adding or eroding impacts than the investment appraisal
Investment appraisals are a waste of time and money. As long as an investment has been identified, the management needs to go and buy or invest in a project as and when the resources are availed. There is no reason why time should be wasted in evaluating the investments.
There are other issues which may prove to be very important in adding value to the organization than investment appraisal, for example, the right kind of staff which is the duty of the Human resources managers will add more value to the organization than investment appraisal (Peter A. 2006) .
But our conclusion is that investment appraisal helps the organization to have the best method and to be able to clearly assess its investment options so that it can be in a position to know where money should be committed. By doing this the organization will also be in a position invest wisely and hence increase its profitability therefore be known to be a good organization.
Therefore, in general terms, investment appraisal helps to increase the value of the organization.
AP Ltd. is trying to evaluate 4 new projects. Assume all the 4 projects have a useful life of 10 years. The projects are mutually exclusive and some of their details are as follows:
Project
Annual Net
Cash flow
Initial
Investment
Cost of Capital
IRR
NPV
1
£100,000
£449,400
14%
A
B
2
£70,000
C
14%
20%
D
3
E
£200,000
F
14%
£35,624
4
G
£300,000
12%
H
£39,000
REQUIRED:
Calculate A, B, C, D, E, F, G and H in the above. Show all calculations. [40%]
A - IRR
For IRR we have to get the rate that would yield an NPV of 0
Therefore
£100000 / (i) = 449400
I= 44%
B- NPV
Year
Cash flow
Rate @14%
NPV
0
-449400
1
-449400
1
100000
0.877
87700
2
100000
0.769
76900
3
100000
0.675
67500
4
100000
0.592
59200
5
100000
0.519
51900
6
100000
0.455
45500
7
100000
0.399
39900
8
100000
0.35
35000
9
100000
0.307
30700
10
100000
0.269
26900
71800
C - Finding initial investment
Annual cash inflow = £70,000
Cost of capital = 14%
Initial investment = x
Initial investment = Annual inflow / cost of capital
= (70000 x 100) / 14
= £500,000
D - NPV
Year
Cash flow
Rate @14%
NPV
0
-500000
1
-500000
1
70000
0.877
61390
2
70000
0.769
53830
3
70000
0.675
47250
4
70000
0.592
41440
5
70000
0.519
36330
6
70000
0.455
31850
7
70000
0.399
27930
8
70000
0.35
24500
9
70000
0.307
21490
10
70000
0.269
18830
-135160
E- Finding Annual Cash flow
F- Finding the cost of capital
G- Annual Net cash flow
Initial investment = £300000
Cost of capital = 12%
Annual cash flow = 300000/12%
=36000
H- Finding the IRR
Which project would your choose? Explain the reasons for your choice.[20%]
From the information provided, the project that will be chosen will be project 1. This is because, project 1 gives a positive NPV of about 78000 and this is after all the years of discounting.
According to Ross G., (2002) The use of NPV measure to evaluate the viability of the project is very important because, NPV brings the future value of money to its present value and so even after the future value of money has been brought to its present value after a period of 10 years, of the investment, the company will make a profit and this means the project is very viable and the company should consider investing in it.
NPV unlike all the other methods of appraisal is more scientific and so its results can be confirmed and trusted.
The NPV for project 1 is much higher than that of the other investments and so its should be chosen as the most viable project.
Unlike the Payback method, which only considers the duration that it takes to pay for an investment, the NPV considers how much will be gained after the prevailing
Discounting rates or constraints have been used (Peter A. 2006).
It is also a method that can be understood and presents logic unlike other methods, which may not be easily understood.
It is against this reasons that the NPV method is chosen. A positive NPV means that there will be profit from the investment and a negative NPV means there will be a loss and so project A gives a positive NPV and should be chosen.
