Appraising investments is a part of the Capital Budgeting Cycle. Investment Appraisal helps to determine the best investment for a business. It allows business managers to evaluate an investment project, and to compare different projects.
What is an investment?
An investment is the purchase of a Fixed Asset with the potential to yield future financial benefits. Basically, it is something that you buy today that you hope will make you money over time. Investment means the purchase of capital goods, or using revenue to improve the business.
There are different types of investments in a business organization:
- Induced Investments include purchasing new capital goods for expansion such as new land and new machines, or more production resources from rising sales such as raw materials.
- Indirect Investments include goods that are needed but are not directly used to generate revenue. For example, office supplies, FAX machines, office furniture, etc.
- Autonomous Investments include replacing old capital goods with new ones such as old and slow machines with new and fast machinery.
To some extent, investments are risky because returns from an investment are only predictions and not guarantees.
Different factors determine investments in the Private Sector from investments in the public sector. While motives (replace equipment, growth, etc.), returns (Is it worthwhile financially?), confidence about the future and external factors (interest rates, TAXes, minimum wage, etc.) impact investments of privately-owned businesses, needs for facilities (schools, stadiums, hospital, culture centers, etc.), political factors and availability of government funds influence investments of government-owned companies.
Can you think of some investments? What makes these investments good or bad?
The Capital Budgeting Cycle in details
One of the key areas of long-term decision-making that firms must tackle is that of investment. The need to commit funds by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed.
We can classify capital expenditure projects into four broad categories based on their purpose:
- Profitability. Improving productivity, quality and location.
- Expansion. Entering new markets and creating new products.
- Maintenance. Replacing old or obsolete assets.
- Indirect. Building social and welfare facilities.
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.
The main stages in the capital budgeting cycle can be summarized as follows:
- Forecasting investment needs.
- Identifying a project or projects to meet those needs.
- Appraising the alternatives using qualitative and quantitative methods.
- Selecting the best alternatives.
- Making the expenditure on Initial Cost of Investment.
- Monitoring the project or projects.
Regarding Investment Appraisal itself, it can be placed in stage three and stage four of this cycle.
One of the most important steps in the Capital Budgeting Cycle is working, out if the benefits of investing large capital sums outweigh the costs of these investments.
Conclusively, even the projects that are unlikely to generate large profits should be subjected to Investment Appraisal. It is because Investment Appraisal may help to find the best solution even though such a project may be unlikely to earn any profits for the company.
