Investment Appraisal

  • Investment Appraisal:
  • Investment appraisal means evaluating the profitability or desirability of an investment project.
  • This usually undertaken through the use of quantitative techniques that assess the financial feasibility of the project.
  • Qualitative methods will also be used when assessing non-financial issues.
  • Some businesses, usually those dominated by a a founding entrepreneur will not apply the formal investment appraisal, and use his/her's 'feel' for what may be a successful project.
  • Quantitative methods of Investment appraisal will make comparisons between the cash outflows or costs of the project and the expected future cash inflows
  • What information is necessary?
  • The initial cost of the investment
  • The estimated life expectancy
  • The residual value of the investment
  • The forecasted net returns or net cash flows of the project
  • Quantitative Methods of Investment Appraisal:
  • 1. Payback Period
  • 2. Average rate of return
  • 3. Net Present Value
  • 4. Internal Rate of Return.
  • Forecasting Cash Flows in an uncertain environment.
  • Forecasted Net Cash Flow : F.C.I - F.C.O
  • These net cash flow figures can then be compared with those of other projects and with initial cost of the investment.
  • With long-term investments where forecasts several years ahead have to be made, there will be increased chances of external factors reducing the accuracy of the figures. E.g: Economic Recession and Increase in resource prices.
  • 1. Payback Method:
  • The Payback period is the length of time it takes for the net cash inflows to pay back the original investment.
  • E.G: If project costs $2m/ expected payback is $500,000 per year = 4 years
  • Year 0= The time period the investment is made = negative cash flow due to expenditure and represent in ("").
  • Why is it important?
  • Managers can compare the payback period of a particular project with other alternative projects so as to put them in rank order.
  • The Payback Period can be compared with a 'cut-off' time period that the business may have laid down.
  • A Business may have borrowed the finance for the investment and a long pay back period will increase interest payments.
  • Some managers are 'risk averse'- they want to reduce risk to a minimum so a quick payback reduces uncertainties for these managers.
  • Advantages:
  • It is quick and easy to calculate.
  • The results are easily understood by managers.
  • The emphasis on speed of return of cash flows gives the benefit of concentrating on the more accurate short-term forecasts of the projects profitability.




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