Investment Appraisal Techniques
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[pic 1][pic 2][pic 3]Table of ContentsIntroduction: 1Purpose of Investment Appraisals: 2Stages of Investment Appraisal: 2Types of Investment Appraisal Techniques 2Non-DCF Techniques 2DCF Techniques 4Conclusion: 7Bibliography: 7Introduction:Investment appraisal techniques are essentially techniques undertaken by companies before they commit to a certain prominent level of capital spend. It involves evaluation and assessment of the expected returns compared to the capital expenditure as well as an approximation of the costs and benefits from the investments. (Kaplan Financial Knowledge Bank, 2012)Purpose of Investment Appraisals:In order to progress and develop, companies need to make new investments to survive in the longer term and secure a sustainable future income. In addition, to make investments, corporations also have to divert a substantial chunk of funds from the profits they make from their existing business to these new projects. Thus, it becomes very significant that all the potential risks vs the expected returns from these investments are evaluated. (Treasury Today, 2004) Potential investments that may need to be appraised include:Diversification into a new product or new marketReplacement or Expansion of an existing operationAcquisition of a new companyObligatory investments in order to meet legal, contractual or environmental needs (Finance and Management Faculty Chartered Accountants’ Hall, 2009)Stages of Investment Appraisal: Initial feasibility Phase (Availability of enough resources for the project)Project Screening Phase (Evaluating the feasibility)Investment Decision Phase (Decision on accepting or rejecting the project)Review and Monitoring Phase (Project progress) (Knowledge Grab, n.d.)Types of Investment Appraisal TechniquesThere are various investment appraisal techniques which are currently being utilized by both manufacturing and non-manufacturing companies. In today’s world, a company will have a number of potential projects to choose from. Thus, it will need a method to compare investments. In case if there is no alternate investment available, it is important to compare the potential return with the opportunity cost of the investment. Thus, acquiring all the relevant information and data in order to form basis of an informed decision becomes extremely important. (Velnampy, 2005)investment appraisal techniques can be divided into two types namely, Discounted and Non-Discounted Cash Flow techniques. (UKESSAYS.COM, 2017)Non-Discounted Cash Flow Techniques: (UKESSAYS.COM, 2017)Payback Method:It is essentially the time period in which initial cash outlay of an project is recouped from the positive cash flows created by the project (Remer & Nieto, 1995). and is expressed in number of years. (Remer & Nieto, 1995).Decision Rule: If the project’s payback period is shorter, it is indeed the better. (BUSINESSESSAYS.NET, n.d.) For this method, the companies first establish a benchmark payback period and then evaluate whether the actual payback period of the project is either more or is less than the benchmark payback period which is established for the project. (Reilly & Brown, 2003)
Critical Analysis of Pros and Cons: AdvantagesDisadvantagesEasy to comprehend and simple to compute (Sangster, 1993), (Remer & Nieto, 1995)This method does not integrate the concept of discounting and risk inculcated in future cash flows (Sangster, 1993), (Remer & Nieto, 1995)Offers perspective to investors and helps them analyse and decide how quickly they can recuperate their initial investment (Sangster, 1993), (Remer & Nieto, 1995)Ignores the cash outflows or inflows beyond the calculated payback period (Sangster, 1993)Crude measure of Project’s liquidity and riskiness (Sangster, 1993), (Remer & Nieto, 1995)Takes short term approach and does not consider the fact that projects that have a prolonged payback period may have higher level of return (Sangster, 1993), (Remer & Nieto, 1995)Application Scenario:This method is extremely useful for organizations that value cash flows available in the short term more than the cash flows in the longer term. (Knowledge Grab, n.d.) It is typically used in scenarios where liquidity is a major concern. The corporation has limited amount of funds and can only accept one project at one point in time. Therefore, its focus will be on recuperating its initial investment at the earliest in order to make room for future projects. (Investopedia, LLC., n.d.)Accounting Rate of Return (ARR):It can be described as the return; an investor expects grounded on the investment he/she has made. (Thirlwall, 1989) It simply uses average profit and then divides it by the initial investment made to get the expected return thus allowing investors to easily contrast potential profits. (Thirlwall, 1989)In calculation, the average profit is essentially the operating profit whereas the investment is described as the book value of the assets that have been utilized in the project. (Wild, 2000) This method recognizes the concept of depreciation and amortization (BUSINESSESSAYS.NET, n.d.) Decision Rule: The higher the ARR, the better. The project should be accepted only if its actual accounting rate of return is either same or more than the required rate of accounting return that has been established for the project. (Scarlett, 2009)