The various businesses
Managers of various businesses will most certainly find themselves in situations where they will have to make decisions on their investments. These decisions will have to affect the future profitability of the project or investments they venture into. This process of ascertaining the profitability of a project can be referred to as investment appraisal. As per Jonathan Sutherland and Diane Canwell in, Key Concepts in Accounting and Finance, investment appraisals can be referred to as the internal appraisal of the potential benefits of a project, which is primarily carried out by the management or employees of a business. In its simplest form, investment appraisal can be referred to as a process whereby a business decides on a particular project because of the profitability of that project taking into account the cost and cash inflows.
Usually, when taking on investment appraisals, there are two questions that need answers. These questions are; (a) should we recommend that the investment in question be undertaken? (b) Given the number of investments or projects which one(s) should we recommend? Investment appraisals must seek therefore to answer the above two questions.
In accordance with the above analysis and definitions, one can say that investment appraisals do add value to business organizations; this is so because so far it shows that it helps businesses to evaluate their projects and therefore make good and objective decisions in favour of their projects. There exist 2 methods of investment appraisals; that is the traditional method which ignores the time value of money and the discounted cash flow method which forecasts cash flows of an investment proposal, to determine their present value. There are two main discounted cash flow techniques available for management these are; the Net Present value (NPV) and the Internal Rate of Return (IRR). How investment appraisals add value to business organisations, and the two main techniques of the discounted cash flow will be discussed in the analysis below.
How investment appraisals add value to business organizations
Investment appraisals capture the incremental changes of benefits and costs arising from a project. The aim of every business is to make an increase in their inputs. Investment appraisal in capturing these incremental changes show the business organization the better and fair project that will bring about these increases hence adding value to the business.
Further, with investment appraisals, cash and other resources are invested in the most profitable way. This is so because the business organization must have selected a project which is less costly and beneficial to the business. That is therefore valuable to the business.
Moreover, realistic project budgets are established for the business organization. Investment appraisal determines the amount of cash inflows over a period of time. It makes the business Management to be aware of what cash outflow will bring about a particular cash inflow hence they plan on the budget that is available for the project.
Risks arising from the investment are considered and measures can be taken to eliminate the risks. If management in the course of an investment appraisal discover that there is a risk involved in a particular investment or project will take immediate action on whether to take the risk or let go the project. Mostly this will depend on the rate of return or on the NPV.
Discounting cash flow technique
The discounted cash flow technique as mentioned in the introduction takes into account both the overall profitability as well as the time value of returns. The techniques to be considered are the Net Present Value (NPV) and the Internal Rates of Return (IRR).
Net Present Value
It measures the difference between the cash inflows from a project and the amount invested in the project. The NPV criteria for accepting a project is to accept when NPV is = 0 and reject when NPV is = 0. The decision becomes indifferent when NPV is = 0. The reasoning behind this is that with an NPV = 0, the return on investment is greater than or equal to required return or cost of capital.
The NPV helps the management to accept or reject a project depending on the results given. It also helps in ranking where there are many projects. The projects are ranked in order of desirability with the highest NPV first if there are budget constraints.
Internal Rate of Return
The IRR, is the discount when used when used in cash flow, which makes the NPV=0 (Key concepts in Accounting and Finance). In other words IRR is the highest rate at which capital employed over the life of a project can be procured without loss on the project. When IRR is > cost of capital, a project can be acceptable.
The IRR has a flaw in that its computation is done by trial and error basis. The essence is to get 2 NPVs one with a negative and the other a positive value and thereafter, the figures are used interpolated to obtain the IRR. In this case the higher the discount rates applied the lower the NPV. Thus if the NPV>0, the discount rate is adjusted upward and if the NPV<0 the discount rate is adjusted downwards.
NPV AND IRR COMPARED
In practice, the use of NPV method is preferred to IRR for various reasons including:
- The IRR rule provides a rate of return rather than the actual size of the gain and sometimes it is important to know the actual size of gain.
- The use of IRR can lead to multiple answers unlike the use of NPV which come out with a unique answer. The number of solutions is determined by the number of times the benefit change signs. So, in some years it may make profit while in others it may make losses.
- The IRR rule tends to favour short life projects rather than those with longer life. It discriminates against projects with long gestation periods.