Investment Appraisal Techniques - Essay Example

Introduction

A capital investment analyst in a company has the duty of informing the boards of directors of the various investment appraisal that can be used in a company to evaluate the viability of a project. The benefits of evaluating a project is that it allows a company to determine which projects, in the case of mutual exclusive projects, will maximize the company profits or as well as shareholder’s wealth. Additionally, it assists in determining the period which a specific project will recuperate the company’s funds. As a capital analyst this is critical in advising the board members of the importance of investment appraisal. There are several investment techniques for the purpose of these report, only three of these methods will be used to assess the viability of the said investment. The investment appraisal technique is selected based on the issue that the decision makers and the shareholders prioritize (McMath and Zeller, 2011).

Executive summary

Capital investment appraisal is very important for any company as it is used to determine the long term and short investments that the company will commit its finances to. This report will focus on three techniques that are commonly used for capital investment appraisal techniques. The net present value (NPV), one of the methods discussed in this report, helps in determination of whether to invest in a piece of equipment or property by determining the difference between the cash flows expected from the project in the future and the initial capital outlay of the project. The payback period, on the other hand, is used to determine the length of time that will be taken to recover the initial costs incurred in a particular project. Finally, the internal rate of return (IRR) is mainly used in a situation where the company has two potential investments that are mutually exclusive. In this case, the IRR is used to determine the best project to invest in. This report will endeavor to explain how each of these methods can be applied in the company as well as highlight the assumptions that are attached to each technique

Net present value (NPV)

NPV entails determining whether the cash flows expected from a particular investment outweigh the initial cost outlay over some determined period (Juhász, 2011). To use the net present value technique in appraising a project, several factors must be known. First, the period over must know, forecasted or expected cash flows, a discounting rate and the initial cost of the project. NPV is computed as follows:

In the case the NPV of the investment in focus is positive, that is, the total discounted cash flows exceed the initial cost outlay then that means the investment is worthwhile and viable (Laan and Teunter, 2000). On the other hand, where the net present value is negative then that means that the investment is not worthwhile since the cash flows expected cannot even cover the initial costs incurred in the investment. A project with a positive NPV is more likely to be profitable than one that has a negative NPV. The net present value technique of capital investment technique is one of the simplest methods of appraising projects and effective as well, but some assumptions accrue to this technique.

Assumptions of Net Present Value

One of the major drawbacks of the NPV technique is that it is heavily dependent on estimates which means that there is wide room for error when using this method. For instance, the cash flows are estimates and the discounting rates used in determining the NPV (Mclean, 2009). Another assumption of NPV is that it does not incorporate hidden costs that are likely to be incurred for the project once it is invested in. The discount rate is used to incorporate the risk factor involved in the project, but it might not sufficiently account for that risk which means that the cash flows may be overstated. These assumptions tend to discredit the effectiveness of the NPV technique. Hence, one may consider other appraisal techniques, two of which are discussed below.

Payback period

The payback period method of investment appraisal aims at determining the period within which costs incurred in a particular project will be recouped (Psunder and Ferlan, 2008). Once the initial cost has been covered, then it means that any other monies generated after that will amount to profits, which is the overall objective of the investor. The payback period is computed as follows:

Payback period= cost of the project/Annual cash flows

Where a company is considering two projects for investment, the project that returns initial cost outlay fast is selected. This is so because the project that has a shorter payback period is considered to be less risky than the one that has a longer payback period (Brown, 2009). The payback period technique is preferred by some investors for several reasons. One of this is that it’s a very simple technique to learn and apply. The payback period, just as any other capital investment appraisal technique is based on various assumptions which indicate the limitations this technique.

Assumptions/Limitations of payback period

One of the assumptions of this technique is that once the useful life of an asset has expired after covering the initial cost incurred on it, there is no chance that the asset will generate any more cash flows. An asset or a project is likely to generate a lot of cash flows and as such the method of investment appraisal must engage several components to account for the complexity of the multitude of cash flows expected (Alesii, 2006). Unfortunately, the payback period is too simple to accommodate this complexity. The optimal investment appraisal technique must account for time value of money and the opportunity costs but payback period does not. Much as the payback period may seem attractive due to its simplicity; one must consider its limitations as well before using it for the purpose of capital investment appraisal.

Internal rate of return

In case a company has two mutually exclusive projects they may be considering for investment, the IRR technique is often used. However, this technique can also be used in evaluating independent projects as well (Magni, 2010). The IRR method uses the try and error method in evaluating projects. It involves using a higher or lower rate of return until the NPV of the cash flows gets to zero. The IRR is probably one of the most complex techniques in capital budgeting, but it has been found to be reliable in various instances. Where a project has a high IRR, then it is considered to be a worthwhile investment. In spite of the complexity of the internal rate of return, this technique has limitations that may disqualify its effectiveness. The IRR is computed as follows:

IRR= lower rate (NPV of lower rate/NPV of higher rate-NPV of lower rate)-(HR-LR)

Assumptions/Limitations of IRR technique

When used to decide on two mutually exclusive projects using the IRR technique, the project that yields the highest IRR is considered for investment. The flip side of this is that the forgone project, though having a low IRR may have a positive NPV, which would increase the shareholder’s wealth (McMath and Zeller, 2011). Under IRR, interim cash flows can be reinvested for projects that have equal rates of return, hence overstating the annual rate of return. This could pose a problem for projects that have a higher internal rates or return because, at the interim period, there is hardly any project that can bring rates of return equivalent to those of the initial project.

Risk management techniques

These strategies are proven methods that managers use in evaluating and analyzing the uncertainty and risks in investing in a certain project. It is important to note that most projects fail to perform due to the failure of incorporating investment appraisal techniques or the due to the wrong interpretation of the signals emanating from the risk measurement and assessment tools. Some of the risk management strategies include the decision tree, maximax, maximin, expected value and the sensitivity analysis. Both the decision tree and expected value are used by managers who are indifferent to the risk provided. In this methods probabilities are utilized to provide a weight of the probable outcomes presented by different events. The main aim of this is to smooth out the impact of factors which of seasonal nature. The maximax is for those managers that are risk takers. In this mode the managers choose an investment that maximizes the highest probable outcome. In this case a payoff table is prepared with the aim of outlining the probable outcome of the decision made based on the different scenarios. Therefore, the managers choose the best from the best available.

The maximin on the other hand is the opposite of maximax. In this case the manager assembles all the worst outcomes and from this they choose the best from the worst. Sensitivity analysis is used to evaluate how the alteration of values of the independent variables will influence a single variable based on various assumptions. In other words, it is used as a way of predicting the results of a particular decision in the case a situation turns out different when compared to the prediction that was available. Risk is often attributed to uncertainty. Uncertainty is the inability to accurately forecast or predict the outcome of future events. Some of the investments techniques incorporate the risk factor to ensure that the results they provide are not overstated. For instance the net present value technique uses the discounting factor to incorporate risk. The investment appraisal techniques that incorporate a risk factor in their computation are the best methods to use in evaluating projects.

Conclusion

The objective of this report has been explaining the importance of capital investment appraisal as well as explaining some of the investment appraisal techniques including the assumptions attached to these appraisal techniques. The company in question intends to invest in some major capital equipment which means that investment appraisal is a necessity. There are several methods or techniques that can be used in appraising projects and the methods highlighted in this report are NPV, IRR and the payback period. It is likely that different companies use different methods to appraise their projects. Either of this methods are applicable, but the fact that each of them is based on certain assumptions which can be considered as the limitations of each of them must not be overlooked.