Capital investment appraisal

Capital Investment Appraisal, also known as Capital Budgeting, is a financial planning process used by businesses to determine whether long-term investments or projects are worth pursuing.
The main purpose of this process is to maximise the company’s future profits by comparing potential investments or projects and ranking them based on their rate of return.

Net Present Value (NPV) method calculates the time value of money, considering the cash inflows and outflows expected in the future, discounted at a specific rate.
If NPV is positive, the project is considered profitable as the present value of benefits outweighs the present value of costs.
If NPV is negative, the project is deemed unprofitable as the present value of costs exceeds that of benefits.

The Internal Rate of Return (IRR) is the discount rate at which the NPV of future cash flows is zero.
IRR is a metric used in capital budgeting that shows the potential return an investment is expected to earn.
Generally, if the IRR of a new project exceeds a company’s required rate of return, that project is desirable.

The Payback Period approach calculates the period it takes for a project to break even or recover the investment outlays.
Although it does not consider the time value of money, it is a simple and quick way to screen potential investments, especially in industries where conditions change rapidly.

The Accounting Rate of Return (ARR) uses accounting information to measure the profitability of an investment.
In this method, accounting profit rather than cash flow is used.
The ARR is calculated by dividing the average annual revenue by the average investment.

Cost of Capital: The cost of funds used for financing a business. If the cost of capital is high, fewer projects will meet the capital investment appraisal criteria.
Cash Flow Forecasting: Future cash flows of a project are not known with certainty. Accounting for this uncertainty can influence the appraisal outcome.
Inflation: Rising prices will impact the future benefit and cost of a project. It’s important to use real cash flows and a real discount rate in appraisal calculations.