What is Investment Appraisal?

There are different techniques used for appraisals. Professionals use discounted cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more techniques like NPV, considering the time value of moneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more, 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.

Key Takeaways

  • 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’ valueShareholders’ ValueShareholder’s value is the value that company shareholders receive as dividends and stock price appreciation due to better decision-making by the management that ultimately results in a company’s growth in sales and profit.read more. 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 investmentReturn On InvestmentThe return on investment formula measures the gain or loss made on an investment relative to the amount invested. The net income divided by the original capital cost of investment. Return on Investment Formula = (Net Profit / Cost of Investment) * 100 read more and risk. For example, management should not decide to construct a new plant, buy machinery, and invest in research and developmentResearch And DevelopmentResearch and Development is an actual pre-planned investigation to gain new scientific or technical knowledge that can be converted into a scheme or formulation for manufacturing/supply/trading, resulting in a business advantage.read more 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 valueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more (NPV), internal rate of returnInternal Rate Of ReturnInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.read more (IRR), profitability indexProfitability IndexThe profitability index shows the relationship between the company projects future cash flows and initial investment by calculating the ratio and analyzing the project viability. One plus dividing the present value of cash flows by initial investment is estimated. It is also known as the profit investment ratio as it analyses the project’s profit.read more (PI), and discounted payback periodDiscounted Payback PeriodThe discounted payback period is when the investment cash flow paybacks the initial investment, based on the time value of money. It determines the expected return from a proposed capital investment opportunity. It adds discounting to the primary payback period determination, significantly enhancing the result accuracy.read more. In contrast, non-discounted techniques include the payback periodPayback PeriodThe payback period refers to the time that a project or investment takes to compensate for its total initial cost. In other words, it is the duration an investment or project requires to attain the break-even point.read more and accounting rate of returnAccounting Rate Of ReturnAccounting Rate of Return refers to the rate of return which is expected to be earned on the investment with respect to investments’ initial cost.read more (ARR).

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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 pointBreak-even PointThe break-even point (BEP) formula denotes the point at which a project becomes profitable. It is determined by dividing the total fixed costs of production by the contribution margin per unit of product manufactured. Break-Even Point in Units = Fixed Costs/Contribution Margin read more. 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.

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 incomeNet IncomeNet income for individuals and businesses refers to the amount of money left after subtracting direct and indirect expenses, taxes, and other deductions from their gross income. The income statement typically mentions it as the last line item, reflecting the profits made by an entity.read more, or net profit as a percentage of the investment.

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 profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more 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 incomeInvestment IncomeInvestment income is the earnings made from allocating funds in financial instruments or assets like securities, mutual funds, bonds, property, etc. It includes dividends on bonds and interest received on bank deposits, profits and capital gain from the sale of real estate and securities. read more 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.

This has been a Guide to what is Investment Appraisal & Definition. We explain investment appraisal’s meaning, techniques/methods, formulas, and examples here. You may also have a look at the following economics articles to learn more –

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.

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.

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.”

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