Different Investment Appraisal Technique Accounting Essays

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Decision making is the key drive force in any organization for its growth. Right decisions help to growth of the organization where as wrong decisions fails to coop with company business strategies , could lead the company in to losses, bankrupts, failures and so on. There fore it is an important fact to have cutting edge methods to facilitate strategic decisions when it comes to decision making especially in financial aspects of the company. The appraisal methods used by many organizations to evaluate capital investments and expected returns. As business environment is getting more complex and rising economic uncertainty investment appraisal methods becoming more challenging due to variations of expected strategical benefits. Long term decision making involves appraising proposed investments the costs and benefits are usually spread over the duration of project, to accept it or reject it. Or else to rank all expected investments to find out the most suitable and profitable project and grade alternative investments accordingly. And also it requires the measurement of project performance up to certain extend.

Challenges

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Investment appraisal boils down to two main areas to influence in finance decisions leads to Capital budgeting to evaluate capital spending on projects, affordability for assets and selection of new healthy projects in order to sustain of the organization. Right allocation of capital is the backbone of the finance of any organization, because it increases the quantify value of the organization through long-term profit gain on invested projects, which benefits the whole organization. These methods can be used in various types of decision making through out the finance function of the organization. Such as R & D, Launching new products, Gain new product lines, diversification, acquisition, affording new assets and so on. Usually it is concerned about the company cash flow and rise of the present value of the company through the right investment on right project. Because it involves a higher risk due to large amount of money spent on selected project, long term commitment for the project, project success decides the satisfaction and share holders' retention, project determines the ultimate value of the company, and so on. Even though the investment decisions made based on today's knowledge and clear understanding of the future, it may critically varied during the period of tine of the project due to high uncertainty, endless competition and complexity of tomorrow's business environment. And also inaccurate decisions may negatively influence market share, profitability and the future survival of the company.

Once the investment is done it cannot be reversed. Therefore it is wise to evaluate all risks before implement the decision to avoid losses and failures. Investments involve large amounts of capital and increase the risk to prevent future liquidity problems it s vital to pre arrange finance and reassure there wont be any finance crisis within the organization due to new investments. Furthermore micro and macro factors heavily influence the future uncertainty and complexity towards the implementation of organizational decisions, could change degree of prediction.

All though the existence of such constrains and limitations been considered when Investment decisions are taken, right forecasting, on the dot estimations, technological competency, investments on innovative projects, positive political influence, could reduce the limitations and enhance the outcomes and expected returns to add value to organizations through effective finance decisions towards the survival and the growth of organization.


Investment appraisal techniques,

Two types of commonly used Investment appraisal techniques.

Non-discounted Cash Flow methods

  1. Pay back Period

  2. Accounting Rate of Return.

    Discounted Cash Flow methods

  3. Net Present Value (NPV)

  4. Internal Rate of Return (IRR)

  5. Profitability Index (PI)

  6. Discounted Pay back period.

Net Present Value Method

The Net Present value approach is one of the commonly used methods of investment proposal techniques. And it's also a main discount cash flow technique which considers the time value of money. NPV approach taking all cash flows in to account, pertaining to total duration of the project, to figure out the actual profitability of the project. Suitable discount rate should be recognized and used to discount the cash flows. Present value of cash flows will calculated by cost of capital as the discount rate. Net Present Value is basically the subtraction of present value of cash outflows of present value of cash inflows. Higher NPV s more accepted. NPV technique based on estimated cash flows and discount rates, mostly shareholder oriented in order to increase the value. (Accounting for non accounting students- Dyson J.R 2007)


Internal Rate of Return (IRR)

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IRR is a commonly used in capital budgeting method. When using IRR it is important to reduce the gap between calculated IRR and real IRR to make decision more effective. Consider the time value of money, all cash flows take in to account when calculating rate of return. IRR technique elaborates on "margin of safety" and "break even point for cost of capital", on a given project.


NPV Vs IRR

The IRR method is more accepted than NPV method. Because IRR is straightforward, it makes use of cash flows and regards the time value of money, as well as NPV. Using IRR method is convenient, and cuts down the drawbacks when real time value is ignored. Some times IRR method provides unacceptable rates of return. Calculated IRR is significantly high when compared with the rate of acceptance. It could tempt the management to accept the project immediately. And also IRR method may give different rates of return. Some times there may be two IRR s could lead present value almost equal to initial investment. When comparing few projects, with NPV and IRR methods could provide different figures. Accepted projects by NPV approach, could be rejected by IRR method. When using NPV and IRR. The discount rate represents the risk of each project. Therefore two projects can be discounted at different rates according to level of risk pertaining to each project. There fore discount rate should be realistic in order to gain a reliable decision. Further more when high IRR is gained it s wise to analyze the possibility of such a IRR and practicality of high theoretical IRR, prior to invest. If not, it's important to reevaluate the project by using more realistic discount rates. (CFA level 1)


Modified IRR (MIRR)

MIRR is not commonly used as IRR method. Modified IRR is similar to IRR. It helps to overcome the drawbacks of IRR method. It avoids different calculated IRR s situation. (Exinfm by Bruner R.)


PROFITABILITY INDEX (PI) or ratio between benefits and cash.

Profitability index method compares the present value of future cash inflows with the initial investment. PI represents the ratio between the present value of cash flows and initial investment of given project. (ICAEW 2002)

PI= present value of cash flow/ initial investment

When PI >= 1, project is accepted PI < 1 project is rejected. It considers the time value of money.

+ NPV 14%

             Cash flow dif.              NPV

100,000             x              5.216             = £5216000

Initial Investment                                      = (£449400)

B                                                              = £72200

-NPV 20%

100,000              x              4.192           = £4192000

Initial investment                                      = (£449400)

                                                                = (£30,200)

IRR = 14% + (72,200/ 72200+30200) x (20%-14%)

                                                           = 14% + (72200/102400) x 6%

A                                                         =18.23%

C. NPV = NCF x Cumm. PU - I. Investment, A= L + C

0 = 70000 x 4.192 - I. Investment

0 = 293440 - I. Investment.

C= Initial Investment= £ 2, 93,440

D. NPV = 70000 x 5.216 - 293440

                                    =365120-293440

D                                 = £71680

E. NPV = Nett Cash in flow - (5.216 x 200000)

             Nett cash flow = £38344

F. NPV= Nett cash flow x Cost of capital - Initial investment

                                     36524= 38,344 x Cost of capital- 200000

Cost of Capital = 238624/38344 = 6.145

F = 10%

G. NPV = NCF X 5.650 - Initial Investment

                                 NCF=339000/5650

                                      G = £60,000

H. 17% = 60,000 x 4.659- 300,000

                               = (20460)

IRR                        = 12% + (39000/39000) x 5%

                              = 12%+ 3.27%

H                           =15.27%

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Project

Annual Net
Cash flow

Initial
Investment

Cost of Capital

IRR

NPV

1

£100,000

£449,400

14%

18.23%

£ 72,200

2

£70,000

£293,440

14%

20%

£71,680

3

£38,344

£200,000

10%

14%

£35,624

4

£60,000

£300,000

12%

15.75%

£39,000

NPV Ranking 1, 2, 4, and 3 IRR ranking 2, 1, 4 and 3 (IRR>= Cost of capital all projects), considered NPV among projects, acceptable ranking is 1, 2, 4, and 3 Project 1 is healthy due to High annual net cash flow, high NPV value.


Conclusion

When using investment appraisal techniques and selecting projects it's wise to consider on important facts, for example Higher IRR, Higher NPV, shorter duration of payback period, and higher ARR. And also consider about other factors like motivating employees, concern all the cash flows pertaining to project against investment, forecast on Inflation and tax, and over view about possible ways to achieve all selected projects.


Reference

Accounting for non accounting students By Dyson J.R 2007

Journal by Bruner R. http://www.investopedia.com/study-guide/cfa-exam/level-1/corporate-finance/cfa13.asp

Journal published by Institute of charted accounts England and Wales. 2004

http://financial.kaplan.co.uk/Documents/ICAEW/MI_Ch3_p.pdf

Bibliography

Investment appraisal managerial approach Pettinger R 2000

Accounting for non accounting students By Dyson J.R 2007

Journal by Bruner R. http://www.investopedia.com/study-guide/cfa-exam/level-1/corporate-finance/cfa13.asp

"Investment appraisal techniques" -chapter 11 published by Institute of charted accounts England and Wales. 2004

http://financial.kaplan.co.uk/Documents/ICAEW/MI_Ch3_p.pdf