Investment Appraisal assesses the attractiveness of different capital projects. These projects usually involve a high level of expenditure and cannot be easily reversed. They also involve a high degree of risk.
‘Never let a poor man advise you on investments.’
A Spanish proverb
One of the key areas of long-term decision-making that firms must tackle is that of investment – the purchase of the Fixed Asset with the potential to yield future financial benefits. The business organization commits funds by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed.
In order to handle these decisions, firms have to assess the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds. Therefore, an important step in the capital budgeting cycle is working out, if the benefits of investing large capital sums outweigh the costs of these investments.
What information is necessary to judge an investment?
Specific numerical information is necessary for quantitative Investment Appraisal techniques. In judging the profitability of an investment project by using quantitative techniques of Investment Appraisal, the following information will be required:
- Initial Cost of Investment. This includes the initial capital cost of the investment, installation costs, workforce training, etc.
- Life Expectancy of Investment. This includes estimated life expectancy of the investment in years. Or, over how many years returns can be expected from the investment.
- Residual Value of Investment. This includes the remaining value of the investment at the end of its useful life when the assets are sold.
- Future Net Cash Flows. This includes forecasted net returns, or Net Cash Flows, or Net Profits, from the investment project. These are the expected returns from the investment minus the running costs of it.
It is assumed that the Cash Inflows are the same as the annual revenues earned from the project, and the Cash Outflows are the annual costs. So, for the purpose of Investment Appraisal, managers consider that:
Sales Revenue = Cash Inflows
and:
Costs = Cash Outflows
so:
Net Profits = Net Cash Flows
These Net Cash Flows figures, or Net Profits, can then be compared with the initial cost of the investment to decide whether this investment is worthwhile. The comparison can also be made with potential returns from other projects to decide which investment should be undertaken.
Main quantitative techniques of Investment Appraisal
Here are five most widely used methods of Investment Appraisal:
A. WITHOUT DISCOUNTING:
1. Payback Period (PBP). This is the length of time required for Net Cash Flows (or Net Profits) to pay back the initial capital cost of the investment.
2. Average Rate of Return (ARR). This shows the annual Net Cash Flows (or Net Profits) arising from a project as a percentage of the initial capital cost of the investment. Or, the annual profitability of an investment as a percentage.
B. WITH DISCOUNTING:
3. Net Present Value (NPV). This shows today’s numerical value of the estimated future Net Cash Flows (or Net Profits) resulting from an investment.
4. Discounted Payback Period. This is the length of time required for Net Cash Flows (or Net Profits) to pay back the initial capital cost of the investment with taking discounting into consideration. Discounting is the process of reducing the value of future Net Cash Flows (or Net Profits) to give them their value in today’s terms.
5. Internal Rate of Return (IRR). This shows the rate of discount that yields Net Present Value (NPV) of zero. Simply, the higher Internal Rate of Return (IRR), the more profitable the investment project is considering the time value of money.
All of the abovementioned techniques used to judge investment projects require forecasts and estimations to be made of future Cash Flows – Cash Inflows and Cash Outflows. Quantitative techniques are used to make comparisons between the current Cash Outflows (Costs) of the project and the expected future Cash Inflows (Sales Revenue). It is done mainly in order to come up with future Net Cash Flows (Net Profits).
How accurate is numerical information in Investment Appraisal?
Forecasting future Cash Flows is difficult and rarely likely to be 100% accurate, hence the risk.
Because the financial data come from the future, the quantitative techniques rely heavily on estimates and forecasts as the numerical information will not be considered as certain or definite. With very long-term investment projects lasting 10, 30 or even 100 years ahead, there will be many internal and external factors reducing the accuracy of the figures.
These future uncertainties cannot be removed anyhow by anyone. Therefore, all managers need to bear in mind that many various events can make the calculations in Investment Appraisal somewhat inaccurate.
In short, when it comes to investments, it is simple. Basically, it is something you buy that you hope will make you money in the future. And, Investment Appraisal helps you to judge how good that something is. It is recommended that in addition to quantitative factors, every business manager should consider Qualitative Factors of Investment Appraisal.
