Welcome to this financial analysis lesson which will focus on the techniques for investment appraisal. After you have finished this lesson, you will be able to first understand the context of investment appraisal for creating value in business. Second, you can learn the investment appraisal techniques used in decision-making and thirdly understand sensitivity and scenario analysis to test whether you are making the correct decision, to begin with.
The aim of investment appraisal is to use available resources to create value in excess of the cost of the investment. In other words, considering the risk involved, the value of the expected future cash flows need to be greater than the investment to be made. And, for investors, investment appraisal is a useful way to gauge the kind of returns the organization is generating.
Investment appraisal also involves asking whether the returns are good enough and the best possible given the estimated risk levels. Investments with less predictable future cash flows will warrant a higher risk profile and vice-versa. The key here is for managers to strike a balance between the level of risk and the level of expected returns.
Investment Appraisal Process
The various steps in the investment appraisal decision process are; the first two steps focus on information gathering and require you to forecast the revenue costs and associated cash flows of your investment, also identify any potential limiting factors such as budget constraints, timings or a need to generate a specific rate of return on the investment.
The next two steps focus on selecting the appropriate investment appraisal technique and setting specific variables such as the discount rate and the time horizon. The final two steps in the process focus on improving the quality of the decision making by constructing sensitivity analysis and what-if type scenarios to help decide whether to consider or reject the investment.
Investment Appraisal Techniques
There are two simple techniques that are frequently used but which measure different outcomes.
The payback method measures the time it takes for you to get your money back and the return on capital employed method measures the amount of value created from the investment.
The two more complex techniques focus on discounting future cash flows and consider both the timing and risk aspect of the investment. The main methods here are the net present value and the internal rate of return. No investment appraisal technique can give the right answer or is the right technique for all situations and an organization may have its own preferred method.
The payback method simply measures how long it will take for the future returns to pay back the initial investment. This method is often suitable for organizations that have a set period. When investments need to be paid back by or there may be a set period, when funding is available for, if the investment payback is within the criterion payback period, then the investment can be considered. The payback method is simple to use and easy to understand and can be used to make a quick first assessment of an investment’s viability. If available capital is in limited supply and there is strong demand payback within a certain period, maybe a critical factor and it considers risk in a simple way which is the length of time, it will take before you recover your investment.
However, the main drawback of the payback method is that it ignores total returns over the life of the project it will favor a short-term project which returns investment quickly but might then tail off and not give long term returns over a longer life. It also looks at paying back the capital only not at how profitable. The return is in practice the payback method is normally used to complement other methods not the main technique.
Return on capital employed or ROCE which is calculated by taking project returns over the capital employed, gives the return generated by the investment by comparing the accounting profit to the required capital outlay of the investment. It is most commonly used by comparing the return to the minimum hurdle rate which must be achieved. This will often be an organization’s cost of capital which is how much it costs an organization to fund the investment such as the interest rate charged for a bank loan.
ROCE can also be used to compare different projects to establish which has the highest return on investment. The ROCE method is simple to use and easy to understand whereas the payback method focuses on the timing of the cash inflow, ROCE focuses on the profitability of the investment. As such, it can give a quick first assessment of the viability of an investment which is usually whether the return is higher than the organization’s minimum hurdle rate.
In addition, you can easily compare the ROCE of different investment options and it allows investors to use the same benchmark to evaluate management’s performance. However, ROCE ignores the time value of money meaning it could take many years to generate the required returns, the quantifiable size of the investment and the value creation is ignored. In addition, the level of risk involved needs to be assessed separately and using Accounting profit rather than cash flows can be open to interpretation.
Now, let’s consider the more complex and time-consuming investment appraisal techniques; net present value and the internal rate of return with NPV; future cash flows are adjusted to the present value to reflect the time value of money by using the discounting process. A key principle of NPV is that the present value of the expected future cash inflows must be at least equal to the present value of any cash outflows for the investment to be worth considering. The discount factor used in the calculation adjusts for risk and timing and the terminal value estimates cash flows after the forecast period into perpetuity.
IRR is when the rate of discount produces a zero NPV. You can think of IRR as the rate of growth a project is expected to generate. A project with a substantially higher IRR value than other available options would likely stand a better chance of being considered. With these discounted cash flow techniques, the time value of money is factored into the investment appraisal of an investment and the inclusion of a discount factor allows managers to include a risk component in the investment. The higher the discount rate, the higher the perceived risk.
The IRR makes it simple to compare investments and benchmark rates with hurdle rates or costs of capital and both methods allow for sensitivity analysis such as variations in the discount rate. However, the increased complexity of these methods does not necessarily result in accuracy. More variables can lead to more areas of uncertainty and some variables may be more sensitive to small changes than others. They can also be time-consuming to produce and if a limiting factor is obvious such as the availability of funding, then a simpler method such as payback may be more appropriate.
Now, that you have understood how to select the appropriate investment appraisal technique, the final steps in the process focus on improving the quality of the decision-making. Here, you can construct sensitivity analysis and what-if type scenarios to help decide whether to consider or reject the investment. Sensitivity analysis looks at the impact of changing one specific variable such as the discount factor or the initial upfront investment or certain costs being higher or lower than forecast.
By contrast, scenario analysis considers many uncertainties in different scenarios such as the emergence of a new competitor or a price war breaking out by creating a given set of scenarios. You can determine how changes in variables will impact the investment outcome and therefore the decision process. In summary, investment appraisal ensures available resources are used to create value in excess of the cost of the investment. There are several investor appraisal techniques available including payback, ROCE, NPV and IRR. When calculating your appraisals ensure you forecast future cash flows, identify any limiting factors and select the most appropriate appraisal technique for your needs. Then, set any variables and finally conduct sensitivity and scenario analysis to consider or reject the investment.
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