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What is investment appraisal?

INVESTMENT APPRAISAL:

There are different methods of investment appraisal which are shown in the figure below,

Payback:

“The payback method is an attempt to estimate how long it would take before a project begins to pay for itself. The recovery of an investment in a project is usually measured in terms of net cash flow. Net cash flow is the difference between cash received and cash paid during a defined period of time.” (J.R Dyson, 2004. p. 478)

“In order to adopt this method, therefore, the following information is required:

  1. The total cost of the investment;
  2. The amount of cash instalments to be paid back on the investment;
  3. The accounting periods in which the instalments will be paid;
  4. The cash receipts and any other cash payments connected with the project;
  5. The accounting periods in which they fall.

As the payback measures the rate of recovery of the original investment in terms of net cash flow, it follows that non-cash items (such as depreciation, and profits and losses on sales of fixed assets) are not taken into account.” (J.R Dyson, 2004. p. 479)

ADVANTAGES:

This is a quite simple and easy method.

DISADVANTAGES:

There are two major disadvantages of this method.

  • In this method we are not looking the value of time.
  • In decision making we are ignoring the cash flows beyond payback time.

Accounting Rate of Return (ARR):

“The accounting rate of return (ARR) method attempts to compare the profit of a project with the capital invested in it. It is usually expressed as a percentage. The formula is as follows:

Profit

ARR = ----------------- × 100

Capital employed

Two important problems arise from this definition. These are as follows:

1 The definition of profit. Normally, the average annual net profit earned by a project would be used. However, as was explained in earlier chapters, accounting profit can be subject to a number of different assumptions and distortions (e.g. depreciation, taxation and inflation), and so it is relatively easy to arrive at different profit levels depending upon the accounting policies adopted. The most common definition is to take profit before interest and taxation. The profit included in the equation would then be a simple average of the profit that the project earns over its entire life.

2 The definition of capital employed. The capital employed could be either the initial capital employed in the project or the average capital employed over its life.

Thus, depending upon the definitions adopted, the ARR may be calculated in one of two ways, as follows:

1 Using the original capital employed:

Average annual net profit before interest and taxation

ARR = ------------------------------------------------- × 100

Initial capital employed on the project

2 Using the average capital employed:

Average annual net profit before interest and taxation

ARR = ------------------------------------------------- × 100

Average annual capital employed on the project *

Initial capital employed + residual value

-------------------------------------

2 .” (J.R Dyson, 2004. p. 484)

ADVANTAGES:

This is a quite simple and easy method and we also start looking in term of profit.

DISADVANTAGES:

  • In this method we are ignoring time value of money.
  • We are using profit instead of cash flow and profit is always calculated subjectively.

Net Present Value (NPV):

“One of the main disadvantages of using the payback and ARR methods in investment appraisal is that both methods ignore the time value of money.

The NPV method recognizes that cash received today is preferable to cash receivable sometime in the future. There is more risk in having to wait for future cash receipts and, while a smaller sum may be obtained now, at least it is available for other purposes. For example, it can be invested, and the subsequent rate of return may then compensate for the smaller amount received now (or at least be equal to it). NPV involves taking the following steps:

  1. Calculates the annual net cash flows expected to arise from the project;
  2. Select an appropriate rate of interest, or required rate of return;
  3. Obtain the discount factors appropriate to the chosen rate of interest or rate of return;
  4. Multiply the annual net cash flow by the appropriate discount factors;
  5. Add together the present values for each of the net cash flows;
  6. Compare the total net present value with the initial outlay;
  7. Accept the project if the total NPV is positive.” (J.R Dyson, 2004. p. 486)

ADVANTAGES:

This method is more focus to liquidity.

  • The basic advantage of this model is that we are taking time value of money in account.
  • It is easy to choose between different projects that which one is best on the basis of NPV.

DISADVANTAGES:

  • By using this method it is difficult to accurately calculate the net cash flow of the whole project till last year and also difficult to estimate the initial cost of project.
  • Rate of interest is difficult to be appropriate.

Internal Rate of Return (IRR):

“An alternative method of investment appraisal based on discounted net cash flow is known as the internal rate of return (IRR). This method is very similar to the NPV method. However, instead of discounting the expected net cash flows by a predetermined rate of return, the IRR method seeks to answer the following question:

What rate of return would be required in order to ensure that the total NPV equals the total initial cost?

In theory, a rate of return that was lower than the entity's required rate of return would be rejected. In practice, however, the IRR would only be one factor to be taken into account in deciding whether to go ahead with the project.

IRR method is similar to the NPV method in two respects:

  1. The initial cost of the project has to be estimated, as well as the future net cash flows arising from the project.
  2. The net cash flows are then discounted to their net present value using discount tables.

The main difference between the two methods is that the IRR method requires a rate of return to be estimated in order to give an NPV equal to the initial cost of the investment. The main difficulty arises in deciding which two rates of return to use so that one will give a positive NPV and the other will give a negative NPV. The range between the two rates should be as narrow as possible. You will find that if you use a trial-and-error method, you may have to try many times before you arrive at two suitable rates!” (J.R Dyson, 2004. p. 488)

IRR = Positive rate + { Positive NPV × Range of rates}

Positive NPV + Negative NPV*

Ignore the negative sign and add the positive NPV to the negative NPV.

ADVANTAGES:

This method is more focus to liquidity and also calculates percentage return.

This method also has influence of timing of the net cash flow.

DISADVANTAGES:

  • This is a very complex method and difficult to understand.
  • It gives us good internal rate of return but it is difficult to understand that which the two suitable rates which we use are.

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