Investments in its common sense are those expenditures or outlay of cash that we engage in now in order to make money out of it in the future. There are many kinds of investment that companies can go into. The investment can be seen as single project or collection of projects.
The issue however is, how are these investments going to be evaluated in the light of prevailing circumstances so as to achieve companies objectives? That brings us to the topic of this hub, to explain what an investment appraisal is and review some arguments that are cropping up now in the academics against the traditional accept-reject criterion.
Investment appraisal is a scientifically based advice on which project to choose and which one not to choose. There are basically three methods used in investment appraisal process. They are
- Accounting rate of return,
- Payback period, and
- Discounted cash-flow
The third is the most important and will take a better part of this hub that however does not mean that we are not going to look at other once. Like I said before, the argument is heating up. I will just explain the traditional idea and then point out some vital points raised in the academics; Accounting and Finance department, University of Glasgow to be precise.
ACCOUNTING RATE OF RETURN METHOD OF INVESTMENT APPRAISAL
Accounting rate of return (ARR) compares annual earnings over a period of time with the amount invested. The averaging is to solve the irregular earnings. This is also known as Return on Capital Employed (ROCE). ARR or ROCE can be calculated in different ways, the most popular way of calculating the ROCE is the one I will be discussing here.
Average annual earnings after depreciation X 100
Any project that does not meet the minimum ARR will be rejected. One major disadvantage of ROCE is that it ignores time-value of money and the minimum targets are subjectively set.
Some of the advantages of ARR are: Easy to calculate and understand, and Helps to keep a business focused
PAYBACK METHOD OF INVESTMENT APPRAISAL
Payback (PB) is defined as the time that lapsed between initial outlay and final recoupment through cash inflows. It has similar advantages and disadvantages with the ROCE method of appraising investment.
DISCOUNTED CASH FLOW
Discounted cash flow (DCF) methods of appraising investments are the most widely favoured methods of evaluating the worthwhile-ness of our projects. The reason for this is that DCF methods take into account of the time value of earnings (money). The amount of money expected at the end of a given period is called the terminal values.
Two or more sets of cash flows can either be compared on a terminal values basis or on a discount basis. Both ways are equally correct, it does not matter which method is used, what will bring confusion is when they are used consistently over time.
The present value approach will be adopted in this hub. In common parlance, PV is seeing the money that will be received later in the future from their present values and then compare them. Outflows of cash are given a negative sign while inflows of cash are given a positive sign.
The resulting difference that comes from the summation of both the positive and negative PVs is called Net Present value (NPV).