Here we cannot say that every investment helps to maximize the profit of a business. So business managers have to find which investment should to be made for the business, then they do so by applying the different methods of capital investments appraisal technique. Investment appraisal helps the managers when they plan for the long term strategy for the organization. In this strategy they take decision on amount which they need to invest in fixed assets and also in working capital, in order to increase and maintain the productive efficiency of an organization.
Normally business managers have many choices to take in the shape of different projects or also each project requires different type of investment. Define capital investment appraisal:- “Capital investment appraisal is a technique where by long-term capital projects may be considered to determine whether such projects are financially viable and worth undertaking or to determine the relative financial viability where there is a choice between alternative competing projects. ” (Cost Accounting-an essential guide).
Investment appraisal technique is a bundle of methods which check the worthiness of projects and also for both public and private sectors. These methods enables the managers to account the ranks among all different projects available for the business and also enables managers to understand the economic life of a project when it has come to an end. The ethical methods of capital investment appraisal are as follows:
- Pay back method
- Annual rate of return method
- Internal rate of return method
- Net present value method
First two methods pay back and ARR of capital investment appraisal are comes under conventional methods and last two (IRR and NPV) methods are comes under discounted cash flow methods. Both methods include the one very important concept ‘time value of money’ Discounted cash flow methods:- These are two main methods which come under the investment appraisal techniques, they both are more likely because the both method does take into account the time value of money. If the money got out of the investment is at least equal to – if not greater than-the money put in. ” (Stephen lumby, 1998) The NPV method works on very commonsense principals. We can better understand this method by taking a simple project ‘A’ which is worth investing in.
In this project it produces a total cash inflow of ? 600 against an outflow of ? 500. that means it has a net positive value of ? 100. Project-A Yearcash flow 0. -? 500 1. +? 300 2. +? 300 =+? 100 = Net value Here we can see the project is worthwhile because it has positive net value. So the main straight forward approach is, we can accept all investments with a positive or zero net value or in other sense accept all the projects who comes with return equals to greater than its cost and reject all investments who comes with negative returns.
Internal rate of return (IRR):
- It is the second another alternative method of capital investment appraisal on discounted net cash flow. There are many similarities between NPV and IRR method.
- “The decision rule is that on IRR greater than or equal to some predetermine ‘cut-off’ rate should be accepted. ” (Stephen Lumby, 1988)
- The above mentioned cut-off in the definition equals to the market rate of interest. All other projects have to reject. The project is only acceptable when it comes with the return at least equal to the return available in the capital market.
The formulation to calculate IRR is as follows:IRR is expressed in percentage form as the true return on investment so it becomes easier to interpret and communicate it to the management.
Advantages and Disadvantages:
- Both NPV and IRR do consider the concept of time value of money.
- The use of net cash flows emphasizes the importance of liquidity.
- Both methods are quite simple to calculate and easy to comparing their results among all projects. •
- In NPV calculation it is not easy to assume the right discounted rate.
- Unrealistic assumptions for cash flows timings.