An Investment Appraisal is the process by which one can assess whether an investment is worthwhile or not.
Dependent upon the size of the organisation an investment appraisal could include the purchase of a new computer for a few hundred pounds right up to the decision to invest in a new manufacturing plant which may result in a £ multi-million investment.
The process of investment appraisal is used by both private and public sector organisations and is the decision mechanism to assess whether or not there is value in investing in a particular project or purchase.
Why do organisations invest?
Generally businesses will invest to increase their profits by improving their operations, to match supply to demand, to reduce manufacturing costs and to increase productivity and/or the efficiency of operations.
In “Not for Profit” organisations the incentive to invest is driven by the need to improve the efficiency, effectiveness and economy of the organisation to provide “Value for Money”
Organisations need to know whether the investment will save money or yield future income streams either directly or indirectly. Investment appraisal is concerned with assessing those savings or income streams in comparison to the overall cost of the investment.
Below are some typical methods used for investment appraisal:
- Pay back period
- Accounting rate of return
- Net Present Value
- Internal Rate of Return (IRR)
- Profitability Index
- Discounted Cash Flow
This is a very simple means of investment appraisal – it works by calculating the length of time it will take for the investment to be paid back – either through the revenue streams created or the savings made.
The calculation below demonstrates this simple investment appraisal method:
|Payback period in years||=||Cost of the Investment|
|Annual cash flows|
The Payback Period investment appraisal concept generally holds that the preferred investment will be the one with the shorter payback period.
It is simple to calculate and for non-financial users, easy to understand, but its very simplicity carries weaknesses
- It encourages short-term projects and disregards those which may make an overall better return, but over the long-term e.g. most major capital intensive construction projects.
- It disregards the time value of money
Accounting rate of return
This compares the accounting profit generated by the investment with the cost of the investment.
The calculation below demonstrates the ARR Investment Appraisal Method
|ARR||=||Average Annual Return or Annual Profit from the investment|
|Initial Cost of Investment|
The ARR investment appraisal concept holds that the preferred investment will be the one producing the higher rate of return, or one that is in excess of the marginal cost of capital of the organisation.
This is relatively simple to calculate, in that the profit from the investment can be extracted from management accounts and takes into account all the income from the investment and rate of return. The ARR investment appraisal concept is easily understood by non-financial managers, but it does have weaknesses.
Its weaknesses are –
- it is purely based on accounting figures and not on cash flow, so working capital requirements of the investment are disregarded.
- accounting conventions such as depreciation can be manipulated, and different accounting standards may restrict comparability between different organisations
- It disregards the time value of money.
Net Present Value
This investment appraisal concept allows businesses to make more informed decisions, allowing them to take into account the time value of money. It is based upon cash in- and out-flows over the whole life of the project discounted for the interest rate of the capital employed.
The time value of money proposes that £1 gained today is more valuable than £1 gained tomorrow, in that £1 gained today can be reinvested, earning interest.
Net Present Value enables comparisons to be made for different projected interest rates.
|PV||=||Sum of all cash flows over n years – C|
Where i = Interest Rate
n = No of Years
C is the cost of investment in year 0
The NPV investment appraisal concept holds that all positive outcomes are acceptable investments, and for competing investments, the one with the higher NPV is to be preferred.
The rate of interest to be used in the calculation should be the rate at which the organisation can obtain funds.
The Net Present Value investment appraisal calculation requires that all cash flows associated with the investment be included. In this way working capital movements are accounted for and actual cash flows are less prone to manipulation. The use of a compound interest calculation automatically accounts for the time value of money.
Its weaknesses are :-
- it is inflexible in that a single interest rate is used over the life of the project.
- Unless accounting systems are geared up to extract cash flows by project, (both actual and forecast), the data upon which the decision is to be made may be estimates between projects.
- Cash timings are notoriously difficult to forecast with precision.
- Most spread-sheets include an NPV function, so easing the calculation.
Internal Rate of Return
The internal rate of return is the interest rate that equates the present value of the expected future receipts to the cost of the investment outlay.
Using the above NPV formula, if the PV is set to zero, the interest rate to produce that answer is calculated.
IRR investment appraisal is used where the interest rate at which an investment can be funded is known, and as long as the rate produced by the investment exceeds the funding rate, the project is viable.
IRR investment appraisal method has the same benefits and weaknesses as NPV investment appraisal method, and most spreadsheets have an IRR function.
The Benefit/Cost Ratio or Profitability Index
The Benefit/Cost Ratio or Profitability index is calculated by dividing the present value of future returns (discounted by the required rate of return) by the required investment outlay.
If the investment value is spread over more than one year, that too is discounted by the required rate of return
|Sum of all cash flows over n years|
|C0 + Cn/(1+i) n|
Independent investments should be accepted whenever the PI is greater than 1.
Where projects are competing, the higher PI is preferable.
Discounted Cash Flow
NPV, IRR and PI investment appraisal methods all make use of the “Discounted Cash Flow” technique, which is now generally accepted as providing the best decision model for investment appraisal, in that cash flows, if properly recorded, are a robust measure of a project’s viability. The time value of money is also accounted for.
Practical Investment Appraisal
All of the above investment appraisal models assume complete certainty in the timing and quantum of both the investment and the returns from the investment and exclude risk.
In practise, however, there is invariably an element of risk and the larger the investment and the longer the period over which the investment is made and the returns to be recovered, the more likely that there will be uncertainty in the cash flows.
Allowance for risk can be built into cash flow projections by applying statistical probability factors and riskier investments can be appropriately discounted. The variable outcomes that occur in the real world, such as the changes in availability of investment funds, the rates at which those funds are offered, the unpredictability of consumer demand, the variability of raw material or labour costs, and actions by competitors can all materially affect assumptions built into investment appraisal models.
For these reasons, successful investment has been likened to an art rather than science. The most successful investors combine rigorous appraisal techniques with flair.