Investment appraisal

Is the techniques for determining whether an investment is likely to be profitable. This is

determination of the concerned firm’s investments, both long term and short term. Investment
appraisal also known as capital investment appraisal which is the budgeting of major capital and
investment to company expenditure. And its estimates of future costs and benefits over the
project's life.
The basic items of investment appraisal are as follows:
i. Payback Period (PBP).
This it states and shows how long does it take for the project to generate sufficient cash-flow to
cover the initial cost of the project. Appraising capital investment on the basis of time that would
be taken to get back your initial investment. Projects with a shorter payback period are usually
preferred for investment when compared to ones with longer pay back periods. The formula is to
take the initial investment and divide by cash flow per year.
Advantages of payback period are as follows;
 Simple to Use and Easy to Understand.
The method needs very few inputs and is relatively easier to calculate than other capital
budgeting methods. All that you need to calculate the payback period is the project’s initial cost
and annual cash flows. For instance, the cost of capital, which other methods use, requires
managers to make several assumptions.
 Quick Solution.
This method helps the managers or investors to make quick decisions, something that is very
important for the companies or business with limited resources.
 Preference for Liquidity.
Determining which projects can generate fast returns is important to companies especially those
with limited resources. Such information is extremely crucial for the small businesses with
limited resources. Small businesses need to quickly recover their cost so as to reinvest it in other
opportunities.
Disadvantages of payback period are as follows;
 Ignores Time Value of Money.
The money received sooner is worth more than the one coming later because of its potential to
earn an additional return if it is reinvested. The PBP method doesn’t consider such a thing, thus
distorting the true value of the cash flows.
 It overlooks capital cost
Pay-back method overlook the costs of capital i.e., interest factor which is an important
consideration in making sound investment decisions. Thus it is no guarantee that it will be
profitable.
 ii. Net Present Value (NPV).
Is the difference between the present value of cash inflows and the present value of cash
outflows over a period of time. Net present value is the sum of discounted future cash inflow &
outflow related to the project. Generally, the weighted average cost of capital (WACC) is the
discounting factor for future cash-flows in net present value method.
Advantages of Net Present Value are as follows;
 Consideration of all Cash Flows.
In the calculation of Net Present Value, both after cash flow and before cash flow over the life
span of the project are considered. NPV takes into account each and every cash flow you define.
 Uses Time Value of Money.
The time-value-of-money principle states that a money received today is worth more than one
received in the future because of its reinvestment potential. When taking this concept several
years into the future, it is easy to see why net present value has an advantage for project
selection.
 Maximizes Company Value.
The higher a project’s Net Present Value, the more it increases your company’s worth. For
example, assume a project has an estimated 10 percent annual return and a Tshs. 100,000 NPV,
while another project has a 7 percent annual return and a Tshs. 150,000 NPV. The second project
will add more value despite its lower rate of return.
Disadvantages of Net present Value as follows;
 Estimation of Opportunity Cost
Determining the opportunity cost might become difficult. This opportunity cost is especially
considered in the initial outlay. Therefore, underestimating the initial outlay will distort the
result.
 Lack of Information
Net present value calculations require copious amounts of information when reviewing multiple
projects. The inability to gather all necessary information or accurate information can weaken
this analysis tool.
 Difficulty in Determining the Required Rate of Return
Determining the rate at which the cash flows are to be discounted might be tough for the
corporate finance team. A firm should not use weighted average cost of capital (WACC) as the
rate but must use the project’s rate of return as a discount rate and thus the wrong estimation may
lead to higher or lower NPVs.
iii. Accounting Rate of Return Method (ARR).
This compares the profit that can be earned by the concerned project to the amount of initial
investment capital that would be required for the project. Projects that can earn a higher rate of
return is naturally preferred over ones with low rate of return.

Advantages of accounting rate of return are as follows;

 It is easy to calculate because it makes use of readily available accounting information.
 It is not concerned with cashflows but rather based upon profits which are reported in
annual accounts and sent to shareholders.
 Unlike payback period method, this method does take into consideration all the years
involved in the life of a project.
 Where a number of capital investment proposals are being considered, a quick decision
can be taken by use of ranking the investment proposals.
 This method gives a clear picture of the profitability of a project. If high profits are
required, this is certainly a way of achieving them.
Disadvantages of Accounting Rate of Return (ARR) are as follows;
 It ignores the time value of money.
 It ignores the cash flow from investment.
 It ignores Terminal Value.
 This method emphasizes the comparison of net present value and disregards the initial
investment involved. Thus, this method may not give dependable results.

iv. Internal Rate of Return (IRR).

Is the minimum discount rate that management uses to identify what capital investments or
future projects will yield an acceptable return and be worth pursuing and is desirable.
Determined as a percentage, it is the interest rate that makes the cash outflows spent on an
investment equal the cash inflows that come into the company as a result of the investment.
You can use the following formula to calculate IRR:
0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n
Where P0, P1 . . . Pn equals the cash flows in periods 1, 2 . . . n, respectively; and
IRR equals the project's internal rate of return.
Advantages of Internal Rate of Return are as follows;
 It considers the time value of money even though the annual cash inflow is even and
uneven.
 The profitability of the project is considered over the entire economic life of the project.
In this way, a true profitability of the project is evaluated.
 There is no need of the pre-determination of cost of capital or cut off rate. Hence, Internal
Rate of Return method is better than Net Present Value method.
 It provides for maximizing profitability.
  Internal Rate of Return takes into account the total cash inflow and outflows.

 It gives much importance to the objective of maximizing shareholder’s wealth.

Disadvantages of Internal Rate of Return are as follows;

 It can provide an incomplete picture of the future.
 It ignores the overall size and scope of the project.
 It ignores future costs within the calculation.
 It does not account for reinvestments.
 It places the top priority of the calculation on profitability.
Here are other items of investment appraisal not mentioned above and are applied is some
projects, these are Modified Internal Rate of Return (MIRR), Adjusted Present Value (APV),
Discounted Payback Period, Modified internal rate of return, Profitability Index and terminal
value which are used in different projects judgment.
CONCLUTION;
Thus from the discussion above I can safely concluding that Firms throughout the world expand
by starting projects and carrying out investments in different industries and sectors. An important
building block in these investments is the analysis and later the evaluation of these projects on
the basis of economic, cost and financial data. Investment appraisal techniques provide the
financial data and also help managers determine the financial viability of each and every project
under consideration.
REFFERENCES
 Bodie Zvi, Kane Alex, Marcus, Allan J, 2002, Investments, Irwin McGraw-Hill Higher
Education, New York.
 Hander Ramesh, January - June 2005, Investment Performance of Manager's Stock
Selection Ability: Empirical Evidence from the Indian Capital Market, Decision.
 Adam, T. & Goyal, V.K. 2008. The investment opportunity set and its proxy variables.
The Journal of Financial Research.
 Reilly F K, Brown K C, 2004, Investment Analysis and Portfolio Management, Shroff
Publishers and Distributors Pvt Limited, Navi Mumbai.