Business enterprises need to make investments this may be big or small investment , however it is required to understand that to what extend it is the investment will be successful and when will the investment will be repaid from the enterprise. Business organizations make investment in long term asset. If capital is limited, proper care should be taken while investing it. Hence comes the importance and role of capital appraisal and management. By investment evaluation criteria means planning and control of capital expenditure.
Investment appraisal is used to calculate weather it is profitable to making an investment. In this type of investment mainly involve big initial payment as capital, and afterward receipts or payments. Investment decision is very important which simply refers to decision about capital investment. Expenditure which is incurred at one point of time whereas the benefit of the expenditure are known at different point of time. It refers to investment in a fixed asset. It can be concluded that capital budgeting is the process of analyzing different proposals and determining whether or not to commit investments to a particular investment proposal whose benefits are to be identified over a period of time more than one year. It is the total process of generating, selecting and analyzing of capital expenditure alternatives. In short, capital budgeting or appraisal means decision as to whether or not money should be invested in long term project.
Important of investment appraisal
Investment appraisal helps in taking a decision whether to invest or not invest on an enterprise. By the help of investment appraisal we can calculate the benefit of the firm at different time. May be the investment will be for five year, by using this we can calculate the benefit obtain in the 3rd year, and so on, the main advantage of investment appraisal is that we are able to identify the future of a enterprise in terms of money and which will lead us take a wise decision about our investment plans. As many are investing a huge amount of money for a long term, a proper planning is needed, investment appraisal is very useful at times of planning as well. Hence investment appraisal is very important in a company's success.
Investment appraisal are mainly divided in to two, traditional and discounted cash flow method.
A traditional method does not consider the time value of money. Which mainly involve following method.
Accounting Rate of Return
This method is also called as Accounting Rate of Return. Under this method average annual profit is expressed as percentage of investment.
ARR = Average income or return / Average investment x100
Pay back method
Payback method is the length of time required to recover the initial cost of the project.
Payback period = original cost of the project / annual net cash inflow.
Discounted Cash Flow Technique
Traditional method does not consider the time value of money. All cash flows are estimated and discounted to give their present value. The important cash flow techniques are
Net present Value method:
The differences between the present value of cash inflows and present value of cash outflow are known as Net present value. The discount rate for obtaining the present value is some desired rate of return which can be equal to the cost of capital.
Internal Rate of Return
Internal rate of return is the rate of return at which total present value of future cash inflow is equal to initial investment or net present value is generally zero. for finding out the rate of return of a project, estimated net cash inflows of each year are discounted at various rates till a rate is obtained at which the present value of cash inflow is equal to the initial investment or net present value reaches to zero.
This method is also called pay-out or pay-off method. This is one of the generally used techniques of evaluating capital expenditure proposals. Pay Back period means the length of time required to recover the initial cost
Calculations of payback period
Payback period = E+B / C
Where, E = Number. of years immediately preceding the year of final recovery
B = Balance amount still to be recovered.
C = Cash flows during the year of final recovery
Payback period of each project:
Project B should accept if AP Ltd imposes 3 year maximum payback period. Because project B have shorter payback period, that is 2.75 years.
Criticisms of payback period
The main criticisms of payback period are, it ignores time value of money and it completely ignores cash inflows after the payback period. This method does not measure profitability of project. It only gives the idea about recovery of the cost of the project. And it does not measure the rate of return.
Net Present Value Method (NPV)
This method is used only when the rate of return on investment is predetermined by the management. In this method present value of all cash inflows are compared against the present value of all cash outflow.
A cash inflow of every year is equal. Therefore here should take annuity rate of last year at 12%. Therefore
Project A and B should be accepted because its net present value is positive. Hence profit will be obtained.
Basic logic behind the net present value method
Net present value method should consider the time value of money, NPV also consider the cash flow stream over the entire life of the project. Moreover it focuses attention on the objective of the maximization of the wealth of the organization. This method is more adaptable when cash inflows are not uniform and it focuses attention on the objective of maximization of wealth of the firm.
The effect of cost of capital on NPV
If cost of capital increased, the net present value of the project will decrease. And if the cost of capital decreased, the net present value will be increased.
Internal rate of return (IRR)
IRR is an investment appraisal method; it does not indicate the rate of return of the project. In order to find out the rate of return of a project, estimated net cash inflows of each year are discounted at various rate till a rate is obtained at which the present value of cash inflow is equal to the initial investment or the net present value reaches to zero. Such rate is known as internal rate of return.
Since the calculated rate of return is more than the desired minimum rate of return Project B should be accepted.
As discount cost of capital increases, there is a decrease in the net present value as well. While decreasing furthermore, it will come to zero and that will represent the internal rate of return.
Net Present Value method to be superior to the internal rate of return method
When we compare these two techniques of investment appraisal, the net present value is considered to be superior because of the following reasons,
- The Net Present value of different project can be added. But the Internal Rate of different project cannot be added.
- Net present value is calculated in terms of currency while internal rate of return is expressed in terms of percentage return a firm expects the capital project to return.
- Net present value method calculates the additional wealth, while internal rate of return method does not calculate the additional wealth.
- The internal rate of return can't be used to evaluate the projects where there are changing cash flows.
- Applying net present value using different discount rates will results in different recommendations, while internal rate of return method always gives the same recommendation.
- Internal rate of Return method provides different rates for different proposals, while reinvestment rate for each proposal is the same in Net Present Value method.
- The use of the internal rate of return method can lead to the belief that a smaller project with a shorter life and earlier cash inflows is preferable to a larger project that will generate more cash in future.
- The Internal Rate of Return method can't work properly if it is comparing two mutually exclusive investment projects of different size or scope.
From the above mentioned methods and examples we can conclude that investment appraisal is the process of analyzing alternative proposals and helps in making decision during various situations in business. It is very useful in analyzing business in various point of time. Mainly used in long term projects usually, and hence the funds can be invested in right organization at right time with a guarantee of making profit.
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