The investment project
A D M T
The purpose of investment appraisal is to assess the economic prospect of a proposed investment project. Investment is a key part of building business. It is a method for calculating the expected return based on cash flow of many, often inter-related project variables. Investment appraisal is what we called long term decision making like, whether a business should invest in a fixed assets or in a new business. Investments in product development, research and development, expertise and new markets can open up exciting growth opportunities.
There are some factors that a business needs to consider is like how much profit will be made from the investment and how quickly the company will recover the cost of investment.
There are two main methods of investment appraisal: Payback and Annual Rate of Return (ARR).
The Payback method is the length of time taken to repay the initial capital costs. The main advantage of using this method is it's simple to use and is very use full if the returns are accurate. It is usually the default technique for smaller businesses and focuses on cash flow, not profit. Payback period focuses on relatively short-term cash flows, it fails to take into account the time value of money and this is the only disadvantage of this method.
The other method is Annual Rate of Return (ARR) which is more complex method of investment appraisal than the payback method. ARR calculates the percentage rate of return on each possible investment. The result percentage figure which comes out by this method allows us to make comparisons with other investment opportunities. It also takes into account the level of profits earned from investment. The ARR is based on profits rather than cash flow. The ARR also fails to take into account the timing of profits.
All the techniques of investment appraisal are relying on accurate calculations to come up with usable answers. An effective appraisal relies on putting in the right figures on right place. For example, the timings of cash flows can have positive or negative effects on the investment project. We may also need help to deal with more complex issues, like the tax implications of different forms of financing, etc.
The main discounted cash flow methods available for business are as follows:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
Net Present Value (NPV):
A business must concern about the value of investing in a particular project should be more than the value it could be lose from not investing in other projects. Discounted cash flow (DCF) helps a business taking decision whether to invest in new project and that the value of money likely to be received in the future is worth today. It takes into account the effect of time on an investment and also shows how interest rates affect the P V of future revenues.
For example, if a business places £1000 in its bank account with 10% interest it will be worth £1100 in a year's time. We can put in another way as well like; £1100 in a year's time is worth £1000 today. By the same calculation, £1000 in a year's time is worth £909.09 (1000 x 1000/1100) today. This is its Present Value (P V).
The Net Present Value (NPV) shows the return on investment less the costs of the project. This would help company to decide whether project is worth investing in it. However, a company has to take other important factors into consideration as well while planning a project, e.g. the value of social or environmental impacts.
Internal Rate of Return (IRR):
IRR also uses discounted cash flow. A business must find the rate of return where the NPV is zero. This is compared to the current market interest rate to assess if the investment would give a fair return than, investing in a bank.
"The basic decision rule for a project appraisal using certainty equivalent values as input and discounted at a rate adjusted for risk is simply to accept or reject the project depending its NPV is positive or negative, respectively."
Similarly when choosing among alternative projects, the decision rule is to select the one with the highest NPV.
NPV will be given first preference, hence in this scenario I would prefer to go with Project No.2. The prime concern of the investor is the return that they going to receive from their investment. The return must be as sufficient as their risk attached to that investment.