INVESTMENT APPRAISAL

Investment appraisal

Investment appraisal

Introduction

The aim of Investment appraisal is to help companies make decisions on which project they should invest in.  The objectives of investment appraisal are to investigate whether:

1)     Capital investment is justified in terms of the expected returns

2)     Any alternatives exist which should be chosen

3)     In cases of fund shortages which project should be undertaken

 

There are four main methods of appraisal that should be looked at: -

1)     Net Present Value (NPV)

2)     Accounting Rate of Return (ARR)

3)     Pay Back

4)     Internal Rate of Return (IRR)

 

Net Present Value

The first calculation we shall look at is Net Present Value.  Net present value is a calculation of how much value the investment will result in.  If the Net Present value is a positive amount then the project should be undertaken.  When being used to determine which mutually exclusive project to undertake the project with the highest NPV should be chosen.  Net Present value is a widely used calculation as it allows for the “time value of money” and allows alternative proposals to be ranked in order of attractiveness.  The main disadvantage of NPV is that it requires the company to calculate an interest rate to use when appraising investment opportunities.  The interest rate is usually the companies Weighted Average Cost of Capital (WACC).  WACC can change and if it does the NPV will have to be re-calculated as the original figure would no longer be valid.

 

Accounting rate of Return

When using the ARR for mutually exclusive projects the project with the highest ARR should be chosen.  However it should also be checked that the ARR meets the minimum requirement.  Although ARR is widely used the calculation does not consider the length of the project, the working capital required or the timing of the cash flows so does not carry the same importance as NPV. 

Pay Back

Pay back is the time it takes to pay back the initial investment from the profit before tax.  When using pay back to analyse two mutually exclusive projects the project that pays back the investment in the quickest time should be chosen.  However there are some disadvantages to pay back.  Firstly any cash flow received after the investment is paid back is ignore with this method and secondly Pay back does not take into consideration the timing of the cash flows or the value of the project.  So although the project may pay back in the quickest time it may also have the lowest return.

 

Internal Rate of Return

Internal Rate of return is the discount rate that if applied to the cash flows of the project would return a net present value of zero.  Having calculated the IRR the company can then accept any projects with an interest rate lower than the IRR and reject any projects with an interest rate higher than the IRR.  Again in the case of mutually exclusive projects the option with the highest IRR should be chosen because it means the interest rate will be able to go up further before the NPV reaches ...