Capital Investment Appraisal within in Organisation - Essay Example

?Capital investment appraisal within an organisation looks at the acquisition of fixed assets so as to generate wealth for the organisation. The wealth generated should be greater than the amount invested. Capital investment appraisal helps to look into future. Uncertainty, risks, complex national and international business environment have added further challenges to the activity of financial long term investment decisions. Long term investment requires capital investment or capital expenditure, which normally comes from top management, visionary corporate leaders (Hilton et al., 2000). Also, more recently the emergence of financial crises in the year of 2008 has asked strategic business investment decision makers to put some extra amount of energy and efforts into the capital investment appraisal. Capital investment appraisal, which is also called capital budgeting, is the process to use funds to acquire operational assets (Khamees et al. 2010). These investment decisions obtain their guidance and source from the outcomes or results, which are provided by the source of capital investment appraisal. If the outcomes of capital investment appraisal are positive and encouraging, and these outcomes show that a particular investment, if taken, would bring wealth and additional inflows to the organisation, then investment or fund managers do not delay or waste a single minute to give a green signal for the investment project. Additionally, that investment project must ensure that after a certain number of years, the investment project would bring some additional inflows which would be more than the initial cost invested into that investment project. Four investment techniques are the different methods: Payback period, discounted payback period, net present value (NPV) and internal rate of return (IRR). These four investment techniques are the basic tools used by the investment managers to carry out the process of investment appraisal. Each investment technique is different and is used differently by the fund or investment managers. Payback period is simply takes into account the number of years. Payback period informs that how many years a particular investment project would take to recover the initial cost of investment. The discounted payback period is a bit different to payback period. The discounted payback period uses a firm’s cost of capital for the purpose of evaluating the expected future cash flows from an investment project. In the discounted payback period, without using the cost of capital, the application of discounted payback period would not be possible and applicable for the purpose of conducting an investment appraisal. Net present value (NPV) is considered to be a more effective and reliable investment appraisal tool in comparison with other tools of investment appraisal. The main reason for its more recognition and more application among the different fund and investment managers is that net present value heavily relies on the technique of time-value of money concepts. The internal rate of return (IRR) is a discount rate. This discount rate is used by many fund and investment managers for the purpose of evaluating the future cash inflows. The only and most important function of the internal rate of return is to give a figure of cost of capital; and this figure is used and applied on the different available cash flows to determine their present value. Capital Investment Appraisal For the financial and investment managers, the activity of capital investment appraisal brings a huge amount of responsibility for them. The capital investment appraisal requires purchasing a long term asset with a life of many years. This means, in case that fixed asset is purchased, the company becomes locked in for the duration of the asset’s life. Also, since the purchase of a fixed asset would directly increase the current level of business operations, and the contribution of the fixed asset would also increase in the activities of sales, costs and so on, it becomes necessary for the investment and fund managers to forecast the possible and probable revenues, which would be forthcoming in the coming years. Or, the revenues would keep coming in the Statement of Comprehensive Income throughout the life of the fixed asset. Additionally, a company’s strategic plan considerably depends on the capital investment appraisal of different strategic decisions. Hence, the entire process of capital investment appraisal has a significant impact on the all major and minor business operations. Payback period The payback period of an investment project suggests the number of years that are required to recover the initial cash investment at the time of initial investment. Or, in the words of Horne and Wachowicz (2003), a payback period is the period of time that is required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. For the payback period, the investment and fund managers have a certain acceptance criterion. This acceptance criterion comes in the shape of number of years and during this period of time, if a particular project brings the revenues that outshine the original figure of investment on the project, this would call for the acceptance of this project; in case, the investment project is unable to bring the required level of inflows during the period specified in the acceptance criteria, then, there is no other way except to reject the investment project. The most important advantage of payback period is that it considerably and appropriately takes into account the liquidity involved in a project. Also, the payback period is considerably helpful to understanding and measuring the level of risk involved in a project. The major drawback of payback period is that it totally ignores the time value of money. Additionally, payback period does not take into account the inflows occurring after the period of payback. On the basis of this, break-up or scrap value would not be taken into account by the payback period. Discounted payback period The use of discounted payback period method discounts the probable and estimated cash flows by using the cost of capital available to be used in a project ( Schweser, 2004). Here, cost of capital is a discount rate. This discount rate is normally used by many investment and fund managers to discount possible cash flows. With the help and use of the cost of capital, fund or investment managers would be able to determine a discounted payback period. Now, after this step, they are required to accept or reject the project on the basis of payback period calculated with the help of discounted payback period. Here, the fund or investment managers would use the same sort of acceptance criterion which is used in the case of payback period. A predetermined payback period is compared with the payback period obtained with the help of discounted payback period. If the discounted payback period comes within the predetermined payback period, the fund or investment manager would accept the project and forward these calculations to the strategic management for the purpose of making a final decision about the project. The most important advantage of discounted payback period is that it takes into account the cost of capital for the purpose of measuring the discounted cash flows of a project. As this method is more reliable and accepted by the many investment managers, the resulting outcomes are mostly considered to be reliable one. The drawback of the discounted payback period is that it does not take into any cash flows beyond the payback period. Net present value (NPV) The net present value of an investment proposal is the present value of the investment project’s net cash flows less the investment project’s initial cash outflow (Horne & Wachowicz, 2003). The most positive and strong point of this investment appraisal technique is that it fully takes into account the concept of time value of money, which is also called as discounted cash flows. While using net present value technique for the purpose of evaluating an investment project’s future cash flows in the present terms, it is highly important to note that if the NPV of the project is a non-negative numeric number or greater than zero, in that case, such investment project must be opted out; then such investment project must be started. On the other hand, if the NPV of the investment project is negative or the future inflows are less than the outflows, in such case, that investment project must not be opted out: It must be avoided for the purpose of making investment. A few years back Payne et al. (1999) expressed that net present value is the most used method after the internal rate of return. Internal rate of return (IRR) The internal rate of return is the rate that equates or equals the present value of a project’s projected or estimated cash inflows with the present value of the project’s cost (Schweser, 2004). The internal rate of return is calculated with the help of trial and error method. This method is used until the appropriate and required rate of return is established. This task of finding a required rate of return is pretty arduous in nature. In order to avoid this process of searching an appropriate rate of return, the use of financial calculator is there to find this rate of return. Also, before going to determine an internal rate of return, it is important for the company to determine the hurdle rate, which is a minimum rate the company will accept for a given project. This determination of hurdle rate would greatly facilitate the process of calculating an internal rate of return. References 1. Hilton, R W, Maher, M W, Selto, F H 2000, Cost Management: Strategies for Business Decisions, McGraw-Hill, Boston, MA. 2. Horne, J C V & Wachowicz J M 2003, Fundamental of financial management, 11th edn, Prentice-Hall, New Delhi. 3. Khamees, BA, Al-Fayoumi, N. & Al-Thuneibat, A A, 2010 Capital budgeting practices in the Jordanian industrial corporations, International Journal of Commerce and Management, 20(1), 49-63.   4. Payne, JD, Heath, WC, Gale, LR (1999), Comparative financial practice in the US and Canada: capital budgeting and risk assessment technique, Financial Practice and Education, Vol.9 pp.16-24. 5. Schweser study program, 2004, Corporate Finance, Portfolio Management, Markets and Equity, Kaplan, USA. Read More