CORPORATE FINANCE

Investment Appraisals & Stock Valuation Methods

Corporate Finance

Investment Appraisal Should Add Value To The Business

In today's highly competitive and rapidly developing business environment, leading companies keen to grow and develop by investing into new projects that can lead them to sustainability and maintenance of their strategic position in the competitive marketplace. Thereby, the businesses always implement strategic planning approach also called 'corporate planning' for long-term that provides a clear direction to the firm towards profitable goals. In strategic planning, one of the most significant areas is strategic decision making by the management of the firm that involves the management of available funds by choosing the right option of investment through using approach of strategic analysis as well as the consideration of whether the chosen options is consistent with the firm's goals and are accepted to the key stockholders (Röhrich, 2007, p.2-3).

In order to fulfil this purpose of evaluating the right investment options, financial managers analyse the available options by taking in account the size of the funds required for the investment, estimated cash inflows and outflows in the future periods, investment's life span, and the extent of risk associated with the option. Eventually, the financial managers choose the best optimal projects that are profitable as well as economical for the business. So, the investment appraisal process is concerned with assessing the value of future cash flows compared to the investment cost (Röhrich, 2007, p.2). Thus, increasingly competitive business atmosphere of today calls for stronger control of costs and requires higher returns while minimizing the associated risks of the investment projects.

The investment appraisal is also known as 'Capital Budgeting' and it involves different methods for evaluating a project. The most significant investment appraisal techniques are discussed below (Röhrich, 2007, p.3-4).

Payback Period (PBP)

Payback Period method was one of the most used investment appraisal technique traditionally. Still some stockholders or companies use this method as this technique results in identifying the amount of time that the investment option will take to recover its initial cost. The use of this appraisal method as a decision making purpose regarding an investment project basically stipulates that all sovereign investments with a payback time less than a specific number of years must be accepted. So, this method specifies that the investment option that provides quickest payback of the initial cost must be selected (Prentice Hall Inc., 2001, n.d).

Investment project's payback period is expressed in years and is determined by using the formula given below (Meredith & Mantel, 2011, p.51):

Payback Period = Required Investment for a Project / Net Annual Cash Flows

According to this technique, the investment that provides a quick recovery of initial cost is taken as desirable, i.e. if the payback period of an investment determined by using above formula is shorter than or equal to the payback period desired by the management; the investment option is accepted otherwise rejected. For example, in case the firm desires to recoup the machine's cost within the five years of purchase, the maximum wanted payback ...