Investment Appraisal is the evaluation of the attractiveness of an investment proposal, which is done using methods such as average rate of return (ARR), internal rate of return (IRR), net present value (NPV), or payback period. Investment appraisal is considered as an integral part of the capital budgeting, and is also applicable to areas where the returns may not be easily quantifiable such as personnel, marketing, and training. Investment is the purchase or creation of assets with the objective of making gains in the future. Investment is a on going continuous process in any company. Investment usually has the risk of the loss of the principal sum.Typically investment involves using financial resources to purchase a machine/ building or other asset, which will then yield returns to an organisation over a period of time in other forms.
When such huge amounts are spent on the company development or future scope, a careful appraisal of the investsments is required. This is beacuse the investments are to be done with atmost care as there are chances of risks involved which are often referred as capital risks. Hence valuation is the method for assessing whether a potential investment is worth to be implemented or not. Investment appraisal usually deals with the planning process of determining whether the firm's long term investments. Efficient allocation of capital resources is a most crucial function of financial management. This function involves organization's decision to invest its resources in long-term assets like land, building facilities, equipment, vehicles, etc. All these assets are extremely important to the firm because, in general, all the organizational profits are derived from the use of its capital in investment in assets which represent a very large commitment of financial resources, and these funds usually remain invested over a long period of time. Hence overall investment appraisal adds more value and safety to the organisation. Investment Appraisal is generally calculated using the Discount Cash Flow.
Regarding the investment decisions, the organisation should need to consider the amount of finance that is available for expansion and the effects that may appear by borrowing money to raise finance. Other investment priorities have to be made by the organisation according to their neccesities.The organisation's financial position also should be considered. The most important criteria which has to be considered before making an investment is the pay back period. Payback period is a simple technique for assessing an investment by seeing how long it would take to be repaid. It is usually the default technique for smaller businesses and focuses on the cashflow. When appraising many investments at a time, where the expected benefits and costs and other cash inflows and outflows arise in a certain period of time, the time value of money plays a very important role. Thus when these steps are perfectly followed and imple, investment appraisal would add a good value to the organisation.
Investment (project) appraisals and capital budgeting, which involve assessing the financial feasibility of a project, should use Discounted Cash Flow (DCF) analysis as a supporting technique to (a) compare costs and benefits in different time periods, and (b) calculate net present value (NPV). NPV utilizes DCF to frame decisions, to focus on those that create the most value.
Discounted cash flow (DCF) is defined as the amount a person or an organisation is ready to pay today in order to receive the anticipated cash flow in coming years. DCF is considered much simpler and flexible than other methods in taking decisions during typical situations of a company, but this is very sensitive towards cash flow estimations, time period and the discount rate. The discount rate in DCF is based on the risks involved of the business and the cost of capital. It can be much clearly explained as the return which one can earn by investing his money somewhere else. The different approaches involved in DCF are:
Equity-Approach :
Flows to Equity Approach (FTE): In this method the, discount the cash flow is available to the holders of capital, after allowing for cost of servicing debt capital. This makes an allowance for the cost of debt capital but the discount rate has to be justified.
Entity-Approach:
Adjusted Present value approach (APV): In this method, the cash flow is discountedwhich flows before allowing for the debt capital. This method is considered advantageous because it is easier to be applied in case if a project is valued where it does not have a debt of capital finance
Weighted average cost of capital approach (WACC):
This method derives a weighted cost of the capital which is obtained from different sources and uses that discount rate to discount the cash flows from the project.
Total cash flow approach (TCF)
This method depicts that the DCF method can be used to know the interest values of the various business ownerships. These can include equity or debt holders. This method can also be used to know the value the company based on the value of total invested capital. In every case, the difference is between the choice of the income stream and discount rate.
2) 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
A) The Net present value is defined as the sum of all the present values (PVs) of the individual cash flows. When all the future cash flows are only inflows and the purchase price is the only outflow, then NPV is simply the NPV of future cash flows minus the purchase price. NPV is a very important tool in used in (DCF) analysis, and is defined as the standard method which uses the time value of money in order to appraise the long-term projects.
The (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments
The formula for calculating the NPV is given as
,
Where,
i= the discount rate (the rate of return that could be earned on an investment)
t= the total time of the cash flow
Rt = the net cash flow (the cash inflow-outflow) calculated at time t
As specfied in the given problem, Rt = 449,000
t = 10 years
i =14%
Thus NPV is solved as:
At t=0, PV = -449000/ (1+1.4)0
At t=1, PV = 449000-
