This assignment focuses on the accounting and decision-making techniques. It deals with the facts related to the choice of projects based on the outputs from the project. It involves the importance on time factor and time value of money in the business.
Investment appraisal is a key factor in long-term decision-making for any business. It is used in both public sector as well as private sectors. The need of funds for a firm for purchasing land, buildings, machinery and so on comes under the investment appraisal. In order to handle these decisions, firms has to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds. This process is termed as Investment Appraisal. Thus, it is a means of assessing whether an investment project is worthwhile or not.
Following are the main stages in the process of investment appraisal:
- forecasting investment needs.
- identifying project to meet needs.
- appraising the alternatives.
- selecting the best alternatives.
- making the expenditure.
- monitoring project.
For these reasons, investment appraisal is of paramount importance. It monitors the capacity and positives and the negatives of a project. It keeps an eye on the investment needs and assesses all the aspects of the project in terms of funds, location, machinery and so on. Investment appraisal helps a business to gain a maximum profit in the best possible time. Even the projects that are unlikely to generate profits should be subjected to investment appraisal. This should help to identify the best way of achieving the project's aims. Here, investment appraisal is important because it may help to find the cheapest way and the minimum time in which the project can be completed.
TYPES OF INVESTMENT APPRAISAL:
- PAYBACK PERIOD
- ACCOUNTING RATE OF RETURN
- NET PRESENT VALUE:
- INTERNAL RATE OF RETURN:
The length of time taken to repay the initial capital cost.
It attempts to compare the profit of a project with the capital invested in it.(Dyson.R.John,2008)
It calculates the annual net cash flows expected to arise from the project.
It assesses the risk associated with an investment project.
The investment appraisal method is used by all the firms so that they can maximize their profit or output in minimum time. It is also important as it takes care of the investment from the initial stage to the final stage. It monitors the working procedure, analyze the conditions and interpret the situation resulting in the profits to the organization. Thus, investment appraisal is inevitable for the success of a business project.
Payback period is the time taken to regain the initial invested capital.It is the time required for the cash inflows from a capital investment project to equal the cash outflows.Thus, time needed to recover the initial investment is called the Payback Period.
If the payback period is of an acceptable length of time to the organization, the project will be selected.(Finance,Groppelli A.A and Nikbakht Ehsan)
Payback Period=Initial Investment / Annual Cash Inflow or Net Cash Flow
- Project A has a payback period of 3 years and 3 months
- Project B has a payback period of 2 years and 9 months
Since B has the quicker payback, it is the preferred project.
CRITICISM OF PAYBACK PERIOD:
- it lacks objectivity.
- ignores the time value of money
- ignores cash flows received after the payback period
- it is not easy to determine an appropriate rate of interest
- biased against long-term projects that take longer time periods to become profitable.
CALCULATION OF NET PRESENT VALUE (NPV)
NET PRESSENT VALUE: the calculation procedure-
- It calculates the annual net cash flows expected to arise from the object.
- It selects an appropriate rate of interest or required rate of return.
- It obtains the discount factors appropriate to the chosen rate of interest or rate of return.
- Multiply the annual net cash flow by the appropriate discount factors.
- Adding together the present values for each of the net cash flows.
- Comparing the total net present value with the initial outlay.
- Accept the project if the total NPV is positive.(Dyson.R.John,2008)
PV= CF n / (l + r) n
The projects have a positive NPV and should be accepted.
LOGIC BEHIND NET PRESENT VALUE APPROACH
The NET PRESENT VALUE approach is considered to be a highly acceptable method of investment appraisal. This is because it takes into account the time value of the money or the timing of the net cash flows, the project's profitability and the return of the original investment. The use of net cash flows emphasizes the importance of liquidity. The NPV assessment makes it easy in the choice of a project. It is easy to compare the NPV of different projects and to reject projects that do not have an acceptable NPV.(Accounting for non-specialists,Michael Jones,2007)
The logic behind the NPV approach is straightforward. If the NPV of the project is positive or zero then the project generates enough cash flows-
- To recover the cost of the investment and
- To enable investors to earn their required rates of return.
EFFECT OF COST OF CAPITAL ON NPV:
NPV is inversely proportional to COC
- If cost of capital increases then the net present value decreases.
- If cost of capital decreases then the net present value increases.
INTERNAL RATE OF RETURN:
Internal Rate of Return is the annual percentage return by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested.(Financial Modeling, Benninga.Simon,2nd Edition)
Aim of IRR:
The aim of IRR is to manipulate that 'what level of interest will the project be able to withstand?'(Financial Modeling, Benninga.Simon,2nd Edition)
EFFECT OF COST OF CAPITAL ON INTERNAL RATE OF RETURN
Internal Rate of Return is independent of Cost of Capital. Therefore, neither IRR of Project A nor IRR of project B will change if the Cost of Capital changes.
WHICH METHOD IS BEST? NPV OR IRR? WHY?
Selection among NPV and IRR depends on which has the better reinvestment rate assumption. The NPV's assumption is normally regarded better than IRR. The reason is follows: a project's cash inflows are generally used as substitutes for outside capital, that is, project's cash flows replace outside capital and, hence, save the firm the cost of outside capital. Therefore, in an opportunity cost sense, a project's cash flows are reinvested at the cost of capital.
This can be better understood through the given projects:
Consider the Project A and Project B. The Project A has IRR 20.9% whereas Project B has IRR 23.8%, so Project B will be chosen. Thus, IRR takes the relative measure into the account and does not give the proper picture of how much amunt of money will be produced from the projects. On the other hand, NPV is an absolute measure which gives monetary answers rather than percentages.
- Accounting for Non-Accounting Students, Dyson.R.John,2008
- Accounting for Non-Accounting Specialists, Jones Michael,2007
- Finance, Groppelli A.A, and Nikbakht Ehsan
- Financial Modeling, Benninga.Simon, 2nd Edition
- Financial Intelligence, Berman Karen and Knight Joe, 2006