Investment Appraisal

1. Introduction to Investment Appraisal

• Investment appraisal is a set of financial techniques used by businesses to evaluate the profitability and feasibility of an investment.
• Investment involves committing financial resources to projects that could:
  • Generate higher revenue.
  • Reduce costs.
  • Improve business efficiency.
• Examples of investments include:
  • Purchasing new machinery.
  • Expanding into new markets.
  • Opening new production facilities.
  • Developing new products.
• Investment appraisal helps businesses decide whether or not to proceed with an investment.

2. Investment Appraisal Techniques

• Various financial techniques are used to evaluate investment decisions, including:
  1. Accounting Rate of Return (ARR)
  2. Payback Period
  3. Net Present Value (NPV)
  4. Internal Rate of Return (IRR)
• Each technique has advantages and limitations, which are assessed before making investment decisions.

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3. Accounting Rate of Return (ARR)

• ARR measures the profitability of an investment by comparing expected profit with the initial investment.
• It is based on accounting profits rather than cash flows.

Formula for ARR:

ARR = (Average Annual Profit / Average Investment) × 100

Where:

• Average Annual Profit = (Total Profit over Investment Life) / (Life of Investment)
• Average Investment = (Initial Investment + Residual Value) / 2

Example Calculation:

• A business buys machinery for $150,000 with a 5-year lifespan and zero residual value.
• Expected annual profit: $16,600.
• Average Investment:

Average Investment = (150,000 + 0) / 2 = 75,000

• ARR Calculation:

ARR = (16,600 / 75,000) × 100 = 22.13%

• Decision: If the company requires a minimum ARR of 20%, the investment is accepted.

Advantages of ARR:

✔ Simple and easy to calculate.
✔ Considers profitability rather than just cash flow.
✔ Useful for comparing projects based on expected return.

Disadvantages of ARR:

✖ Ignores the time value of money.
✖ Based on accounting profits, which may be subjective.
✖ Does not consider the project’s lifespan after the calculation period.

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4. Payback Period

• The payback period measures how quickly the initial investment is recovered through net cash inflows.
• A shorter payback period is preferred, as it reduces risk.

Formula for Payback Period:

Payback Period = Initial Investment / Annual Net Cash Flow

Example Calculation:

• A company invests $100,000 in a project.
• Expected annual cash inflow: $25,000.
• Payback Calculation:

Payback Period = 100,000 / 25,000 = 4 years

• Decision: If the company’s acceptable payback period is 5 years, the investment is approved.

Advantages of Payback Period:

✔ Simple and easy to use.
✔ Measures the liquidity of an investment.
✔ Useful in high-risk industries where quick recovery is essential.

Disadvantages of Payback Period:

✖ Ignores profitability beyond the payback period.
✖ Does not consider the time value of money.
✖ Ignores cash inflows after recovery of initial investment.

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5. Net Present Value (NPV)

• NPV accounts for the time value of money, discounting future cash inflows to present value.
• A project is accepted if NPV is positive.

Formula for NPV:

NPV = Σ (Net Cash Flow / (1 + Discount Rate)^Year) - Initial Investment

Example Calculation:

• Investment: $130,000
• Annual Net Cash Flows:
  • Year 1: $50,000
  • Year 2: $50,000
  • Year 3: $30,000
  • Year 4: $25,000
  • Year 5: $20,000
• Discount Rate: 10%
• Present Value Factors:

  Year 1: 0.909
  Year 2: 0.826
  Year 3: 0.751
  Year 4: 0.683
  Year 5: 0.621
  

• Discounted Cash Flow Calculation:

NPV = (50,000 × 0.909) + (50,000 × 0.826) + (30,000 × 0.751) + (25,000 × 0.683) + (20,000 × 0.621) - 130,000

• Final NPV Decision:
  • If NPV > 0, the investment is approved.
  • If NPV < 0, the investment is rejected.

Advantages of NPV:

✔ Accounts for time value of money.
✔ Considers all cash flows.
✔ Provides a clear profitability indicator.

Disadvantages of NPV:

✖ Requires estimation of discount rate.
✖ Can be complex for non-financial managers.
✖ Not effective for comparing projects of different sizes.

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6. Internal Rate of Return (IRR)

• IRR is the discount rate that makes NPV = 0.
• It represents the project’s expected return.

Formula for IRR (Interpolation Method):

IRR = Lower Discount Rate + [(NPV at Lower Rate / (NPV at Lower - NPV at Higher)) × (Higher Rate - Lower Rate)]

Example Calculation:

• NPV at 10% = $14,000
• NPV at 18% = -$6,000

IRR = 10% + [(14,000 / (14,000 + 6,000)) × (18% - 10%)]

• Final IRR Decision:
  • If IRR > cost of capital, investment is approved.
  • If IRR < cost of capital, investment is rejected.

Advantages of IRR:

✔ Provides a rate of return that is easy to compare.
✔ Considers the time value of money.
✔ Takes into account all cash flows.

Disadvantages of IRR:

✖ Difficult to calculate for projects with irregular cash flows.
✖ Assumes reinvestment at IRR, which may not be realistic.

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7. Non-Financial Factors in Investment Decisions

• Human Resources: Job creation, redundancy risks.
• Environmental Impact: Pollution, sustainability.
• Social Considerations: Local community impact.
• Legal & Ethical Considerations: Compliance with regulations.
• Strategic Fit: Alignment with company goals.

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8. Choosing the Best Investment

• Businesses prioritize projects based on:
  • Capital rationing (limited funds).
  • Highest NPV or IRR.
  • Fastest payback period.

Example Investment Selection:

Project	Capital Cost	NPV	Profitability Index
A	$200,000	$100,000	0.50
B	$300,000	$80,000	0.27
C	$500,000	$270,000	0.54
D	$200,000	$180,000	0.90

• Best Choice: Projects D and E maximize NPV.