Every decision made within a decision environment, which is defined as the collection of information, alternatives, values and preferences available at the time of decision. An ideal investment decision making would include all possible information, all of it accurate, and every possible alternative. However, both information and alternatives are constrained because the time and effort to gain information or identify alternatives are limited. The time constraint simply means that a decision must be made by a certain time. The effort constraints reflect the limits of manpower, money and priorities. Since investment decision must be made within these constrained environments, we can say that the major challenge of decision making is uncertainty. Almost all decision making process involves an undeniable amount of risk and uncertainty.
Investment is key part of building the business. New assets such as machinery, furniture and other equipments reduce costs and increase productivity. Investments in product development, research and development, expertise and new markets can open up exciting growth opportunities. Even a project that is unlikely to generate a profit should be subjected to investment appraisal to identify the best way to achieve its aims.
Investment appraisal is an important part of decision making. It is concerned with the allocation of the firm's scarce financial resources among the variable market opportunities. The consideration of the investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of expenditures for it. It consists in employment of available capital for the purpose of maximizing the long term profitability of the firm.
IMPORTANCE OF INVESTMENT APPRAISAL
Individuals make investments in their homes, automobiles, furniture, major appliances and other long-lived assets. Business enterprises also make investments in long term assets. Since capital is limited, greater care should be taken while taken it. Here arises the importance of investment appraisal.
Investment appraisal simply refers to the decision about capital investment. It is the process of analyzing alternative proposals and deciding whether or not to commit funds to a particular investment proposal (long term project) whose benefits are to be realized over a period of time longer than one year. It helps the investor to generate, evaluate, select and follow up of investment alternatives. In short, investment appraisal means decision as to whether or not money should be invested in long term projects.
Investment appraisal is concerned with heavy expenditure decisions. The benefits or returns from such expenditure are expected to be derived over many years in future. These decisions affect the long term flexibility and profitability of the enterprise. Success or failure of an enterprise is dependent upon the quality of investment appraisal alone in that enterprise. The methods for doing investment appraisal are broadly classified into two, traditional and discounted cash flow methods.TRADITONAL METHODS.
Traditional methods do not take into consideration the time value of money.Important traditional methods of doing investment appraisal are;
- ACCOUNTING RATE OF RETURN(ARR).
- PAY BACK METHOD.
Under this method, average annual profit after tax is expressed as percentage of investment. It is found out by dividing average income by the average investment.
Accounting Rate of Return = Average income or return/ Average investment x 100.
This is one of the commonly used techniques of evaluating investment proposals. Payback period is the length of time required to recover the initial cost of the project. In short, it is the period required to recover the cost of investment.
Pay Back Period = Original cost of project (cash outlay)/ Annual net cash inflow.
The discounted cash flow techniques or present value methods are based on the principle that money has time value. It considers the cash flow stream over the entire life of the project. The important discounted cash flow techniques are;
- NET PRESENT VALUE (NPV).
- INTERNAL RATE OF RETURN (IRR).
Under the net present value method, the present value of all cash inflows (stream of benefits) is compared against the present value of all cash outflows cost of investment).The difference between the present value of cash inflow and cash outflow is called the net present value. The discount rate for obtaining the present value is some desired rate of return which may be equal to the cost of capital. This method is used only when the rate of return on investment is predetermined by the management.
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 zero. In order to find 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 comes to zero. In IRR, we try discounting at different discount rates until we reach the discount rate which equates discounted investments and the discounted inflows. This rate is called the internal rate because it exclusively depends on the initial outlay and cash proceeds associated with the project and not by any other rate outside the investment.
CRITICISMS OF PAYBACK PERIOD.
- It ignores the time value of money.
- It completely ignores cash inflows after the payback period.
- In case of long term projects, sometimes a project having higher payback period may be better than lower payback period owing to higher return after payback period.
- It does not measure the profitability of projects. It insists only on recovery of the cost of the project.
- It does not measure the rate of return.
LOGIC BEHIND NET PRESENT VALUE METHOD.
- It takes into account the time value of money.
- The minimum desired rate of return (cost of capital) is assumed to be known.
- It implies that the cash inflows are invested at the rate of firm's cost of capital.
- The Net Present Value of different projects can be added.
- It considers the cash flow stream over the entire life of the project.
- Net Present Value method is most suitable when cash inflows are not uniform.
- It focuses attention on the objective of maximization of wealth of the firm.
If cost of capital increased, the Net Present Value of a project will be decreased. On the other hand, if cost of capital decreased, the Net Present Value will be increased.
For example, in Project A if we increase the cost of capital from 12 to 15%, the net present value will decrease from 31740 to 19790.
On the other hand, if we decrease the cost of capital from 12 to 10%, the net present value will increase to 38520 from 31740.
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 curresponding decrease in the net present value . While deceasing furthermore, it will comes to zero and that will represent the internal rate of return.
Net Present Value method is regarded to be superior to the Internal Rate of Return method:
While comparing the two important techniques of investment appraisal, the Net Present Value is considered to be superior because;
- 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.
- When there are no budget constraints, Net Present Value is particularly appropriate as compared to Internal Rate of Return method.
- The Internal Rate of Return method can't work properly if it is comparing two mutually exclusive investment projects of different size or scope.
- 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.
- 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.
- Applying net present value using different discount rates will results in different recommendations, while internal rate of return method always gives the same recommendation.
To conclude, investment appraisal is the evaluation of attractiveness of an investment proposal, using methods such as payback period, average rate of return, net present value or internal rate of return. It is an integral part of capital budgeting, and is applicable to areas where the return may not be easily quantifiable such as personnel, marketing and training.
Investment appraisal concerned with maximizing share holders wealth. Apart from share holders, other parties such as suppliers, lenders, employees, managers, as well as general public need to be to be taken into account in assessing a project's viability. Furthermore, the quantitatitative aspects of the projects are very important and this leads on to the data content needed to evaluate a project effectively. The cash inflows and outflows are simply the standard means of translating into a common base of numbers all the underlying quantitative avd qualitative assumptions, which are the real determinants of projects viability. The management needs to consider carefully thestrengths and weaknesses of these assumptions before finally converting them to the cash flows.
Investment appraisal decisions are very difficult to make. This decision involves forecasting of future conditions for estimating the future cash flows and costs of different projects. The benefits and costs are affected by economic, political, and technological forces. So the success and failure of a business is largely depends on the quality of investment appraisal.