Investment Appraisal

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What is Investment Appraisal?

Investment appraisal refers to the techniques used by firms and investors primarily to determine whether an investment is profit-making or not. The examples include assessing the profitability and affordability of investing in long-term projects, new products, machinery, etc.

There are different techniques used for appraisals. Professionals use discounted cash flow techniques like NPV, considering the time value of money, giving highly accurate results. At the same time, they also use non-discounted techniques like payback period giving less accurate results since it does not incorporate the time value of money concept. Using more than one method gives a better insight into the investment opportunity.

Table of contents
  • Investment appraisal definition portrays it as the techniques used by firms and investors to determine whether an investment is profit-making or not. 
  • The examples include assessing the profitability and affordability of investing in long-term projects, new products, machinery, etc.
  • Its methods are categorized into discounted and non-discounted techniques.
  • Examples of commonly used discounted techniques are net present value (NPV), internal rate of return (IRR), profitability index (PI), and discounted payback period. In contrast, non-discounted techniques include the payback period and ARR.

Investment Appraisal Explained

The investment appraisal process is used by professionals to examine whether the investment option under consideration is good for the firm or not. However, it isn't easy to ensure that an examination will be 100% accurate. Every investment entails risks. However, appraisals facilitate management in making rational choices based on the expected outcomes. Furthermore, management must align investment decisions with the objective of maximization of shareholders' value. Hence conducting the valuation technique helps them corroborate the future cash inflows from the investment.

The process is crucial when the investment involves a large sum of money, scarce resources, etc. In such cases, the entities cannot rely on subjective data; they need a combination of quantitative and qualitative aspects to analyze the return on investment and risk. For example, management should not decide to construct a new plant, buy machinery, and invest in research and development without evidence of their initial outlay producing good future cash inflows.

The input to appraisal technique is another important observation. The projected future cash flows and discount rate are the two key inputs. Other essential factors to be considered include investment's environmental impact, social impact, operational benefits, risk elements, and legal considerations.

Investment Appraisal Techniques

The investment appraisal methods are categorized into discounted and non-discounted techniques. Examples of commonly used discounted techniques are net present value (NPV), internal rate of return (IRR), profitability index (PI), and discounted payback period. In contrast, non-discounted techniques include the payback period and accounting rate of return (ARR).

Investment Appraisal Techniques

In detail, let’s discuss the investment appraisal techniques like payback period, accounting rate of return, and net present value.

a. Payback Period

The payback period refers to the period representing the time required by a project to recover the investment cost. It is the anticipation of when the investment will reach the break-even point. It occurs when an amount equal to the initial capital invested is generated from the project, so it's a point of no profit and no loss.

Payback period

Investors often desire a shorter payback period. It indicates a faster cash inflow, points to sustainability and contributes to the investment attractiveness.

b. Accounting Rate of Return

The accounting rate of return expresses annual accounting earnings, the net income, or net profit as a percentage of the investment.

Accounting Rate of Return

The level of good ARR varies with industry or businesses; the investors or management accepts the projects if the ARR is above the required level and vice versa. Therefore, when comparing two projects, the one with high ARR will be a desirable option.

c. Net Present Value

NPV method takes into account the time value of money. It analyzes the profitability of a project by finding the present value of future cash flows over a period and deducting it from the initial cash investment.

NPV = Present value of future cash flows – Initial cash investment

A positive NPV indicates that the project generates profit. At the same time, negative NPV means the vice versa scenario, and it is safe not to pursue the project or investment option.

Example of Investment Appraisal

Consider the example of a property investment appraisal to better understand the practical application of appraisal techniques.

The specialists or valuers employ discounted cash flow methodologies to estimate the property's worth. It includes discounting future elements such as investment income and costs to account for the time value of money. Hence, this valuation procedure aids in estimating the factors like selling price, investment value, and purchase price of a property. This outcome can be used to identify whether the market is under-or over-priced and influence investors and other market participants when buying and selling real estate.

Frequently Asked Questions (FAQs)

Define investment appraisal meaning?

It is the process of evaluating an investment opportunity to understand whether it is profitable to the organization or not. The process primarily focuses on assessing the economic feasibility of the proposed investment or project.

Why is investment appraisal important?

It forms an important element of fundamental analysis for many businesses and investors. For example, the method derives whether the project under appraisal process yields profit or loss in the future, the time it takes to return the benefit and risk associated, etc. Different appraisal techniques give results in numerical terms, and having quantitative results reduces the complexity of management decision-making.

What is the investment appraisal formula?

The formula varies with the technique used for appraisal. For example, if the profitability index technique is used, the formula will be "present value of future cash flows divided by the initial investment." Whereas, if the method used is the payback period, the formula is "initial investment divided by cash flow per year."