INVESTMENT APPRAISAL

Investment Appraisal



Investment Appraisal

a) Investment Appraisal

Yes, I agree.

Investment appraisal is the process by which a business decides whether a large-scale project can be afforded. Businesses will look at the projected cost of the project, at the possible risk factors, and at the benefits that might accrue. The process means that one project can be compared against another and a judgement made as to which is likely to be the most successful.

For any sort of capital project, a business needs to make capital investment decisions. This means that they have to estimate future costs from the base of current costs and try to accurately forecast the levels of future revenues. Costs can only be estimated using current prices; revenues must be estimated over the projected life span. Businesses use four main techniques to make such estimates as accurate as possible. These are Average Rate of Return (ARR), Payback, Net Present Value (NPV) and Internal Rate of Return (IRR).

ARR looks at the likely returns the business will get from a completed project over its forecast life span. If the returns will be greater than the cost, in a short enough time period, the project can go ahead. Payback estimates the length of time it will take for the business to recover its cost in revenues. NPV links the value of returns to predicted inflation rates. It also takes into account predictions on currency fluctuations. Future returns are estimated and then reduced in accordance with predictions regarding the spending power of money in the future. This is called discounting the cash flow. Businesses will also compare possible discounted rates of return with predictions of what could be gained from safe investments. IRR approaches the problem in the same way as NPV, but from the other direction. It looks for the point in the project life span at which NPV is zero and then calculates the interest rate that would be necessary to get the same return.

b) Payback Period

The time, in no. of years, needed to recover a project's initial outlay of cash flow investment is called payback. It is the most highly utilized traditional way of determining the value of investment proposals and is even the most popular one.

Calculation of Payback period:

Payback period is calculated, using cumulative cash flow, which can be calculated using the following formula.

Cumulative Cash flow for a given date = Sum of all cash inflows - Sum of all cash outflows

Project A

No. of Years

Net Cash Flow

Cumulative Cash Flow

1

£ 22,000.00

£ 22,000.00

2

£ 31,000.00

£ 53,000.00

3

£ 43,000.00

£ 96,000.00

4

€ 52,000.00

£ 148,000.00

5

€ 71,000.00

£ 219,000.00

Payback period = 3 years + (125,000-96,000)

52,000

= 3.56 years

Project B

In project B, it can be observed that a fixed sum of cash flow is incurred each year. This pattern is termed as 'annuity'. Therefore, payback period of an annuity can be calculated using the following formula:

Payback period of annuity = Initial Investment

NCF per period

Payback period = 125,000

43000

=2.91 years

Suggestion

There is a condition of a payback period for the acceptance of any ...