A company may decide to invest in a long-term project if the future return is likely to be achieved. Financial managers will make estimations/projections and use techniques to identify whether the investment is appropriate. This is known as investment appraisal.
Investment appraisal is crucial to a business due to:
- Large sums are necessary to invest in projects and therefore care needs to be taken with the decisions, as they are difficult to reverse.
- It is difficult to estimate the potential future return of long-term investment so investment appraisal techniques need to be used to assess the risk and uncertainty of projects.
Before any investment decisions can be made, the following need to be considered:
- Initial Investigation – Feasibility of project (eg Do we have enough resources).
- Project screening – Evaluating the feasibility of a project using techniques such as (NPV, IRR etc)
- Analysis and Acceptance – Decision has to be made on whether to invest or not.
- Monitoring project – Analyse the progress of the project and reassess forecasts.
To measure whether the benefits of a project exceed the cost of investment, various investment appraisal techniques are available namely discounted and non-discounted cash flow techniques.
Non-discounted cash flows do not consider the time value of money (Inflation) but are useful techniques for the analysis of projects.
A non-discounted technique that gives an estimation of the amount of time it will take to cover costs of investment, usually expressed in years.
|Simple method to understand.||Takes no consideration of the time value of money.|
|Provides an estimation based upon cash flows for businesses that value short-term cash flow more than longer-term cash flow.||Ignores the fact that some of the projects with longer payback periods have a greater level of return.|
Accounting Rate of Return (ARR) or Return on Capital Employed (ROCE)
The return on capital employed expresses the investment return as a percentage. This technique takes into account the amount of capital investment necessary to back-up the project. Note it uses profits rather than cash flows.
|Simple method to understand and calculate.||Fails to consider the timings of cash flows.|
|Allows share option availability to employees as an incentive.||Public companies have to meet certain regulatory requirements and accepted standards of corporate governance.|
Discounted Cash Flow Techniques
Discounted cash flow takes into account the time value of money (Inflation) and therefore is a more accurate measure of appraisal.
Net Present Value (NPV)
The net present value takes into account the profitability by analysing cash flows over the life of the project. It uses the cost of capital to discount the cash flows.
|Takes into account the time value of money so makes it more accurate.||Fails to consider the timings of cash flow|
|Helps to determine profitability of projects using cash flows rather than profits.||There may be difficulties in determining an appropriate cost of capital.|
Note that a positive NPV is normally accepted whilst a negative NPV is rejected.
Internal Rate of Return (IRR)
The Internal rate of return determines the cost of capital at which the NPV is zero.
|Simple to understand because it is expressed as a percentag.||Fails to consider the risk and uncertainty factors involved in a project.|
|Takes into account the time value of money.||Public companies have to meet certain regulatory requirements and accepted standards of corporate governance..|
Note in order to calculate the IRR, the NPV needs to be calculated at two different costs of capital rates.
Taxation and Inflation
It is important to be aware of the appraisal techniques that consider the effects of taxation and inflation. Most businesses in practice will do so as this will affect the accuracy of appraisals.
Inflation on Interest Rates
There are two methods used to for discounting cash flows when considering inflation, namely real method and money/nominal method.
- Nominal method is used when a project has actual cash flows. Normally used when project includes both tax and inflation.
- Real values are used when a project’s cash flows are expressed at today’s price levels. Normally used for annuities and perpetuities.
Taxation has to be taken into consideration when making investment decisions. Tax will have to be considered in cash flows of the project when discounting to arrive at the project’s NPV.
Tax is assumed to be paid a year in arrears when doing discount cash flow analysis.
Note it is important to consider the tax consequences of projects in particular:
- Capital Allowances v Depreciation
- Disposal Issues