The Concept of Investment Appraisal

The Concept of Investment Appraisal

Understanding Investment Appraisal

  • Investment Appraisal refers to the process of determining whether a planned investment will provide an adequate return or not. It is a crucial element in long term decision-making.

  • An investment generally involves a significant outflow of resources (money, time, effort) that is expected to generate a return over time.

  • Businesses typically use investment appraisal techniques to assess the viability of large projects or the purchase of new equipment, amongst other potential investments.

  • The key reason for doing an Investment Appraisal is to avoid making poor investment decisions and thus mitigate the risk of loss.

  • Knowledge of different appraisal methods helps businesses evaluate the variety of investment opportunities available to them.

Investment Appraisal Techniques

  • The four primary techniques employed in investment appraisal are Payback Period, Accounting Rate of Return (ARR), Net Present Value (NPV), and Internal Rate of Return (IRR).

  • The Payback Period calculates the time it will take for the original investment to be recouped from cash inflows generated by the investment.

  • Accounting Rate of Return is a profitability measure which calculates the return an investment will generate as a percentage of the initial investment.

  • The Net Present Value method calculates the value of cash inflows and outflows today (the present value), acknowledging that a pound today is worth more than a pound in the future.

  • The Internal Rate of Return technique calculates the discount rate at which the net present value of an investment becomes zero, making it useful to compare different investments.

Factors Influencing Investment Appraisal

  • Decisions regarding investment appraisal are influenced by factors like the purpose of investment, the cost of capital, the investment’s risk profile, the available budget, the projected cash flows, and the expected rate of return.

  • Understanding the time value of money is essential as future cash flows are worth less than immediate ones due to inflation, risk, and lost opportunity costs.

  • Businesses need to consider the risk and uncertainty associated with the investment. Higher levels of risk may warrant a higher expected return.

  • Finally, the strategic fit of potential investments should be considered – how well does the investment align with the business’s long-term strategy.