Investment appraisal
Investment appraisal is a number of methods used to classify the attractiveness of an investment.
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Investment appraisal actually from Investment decision, Which project has to finance, the Business has to make the investment, And you have to pick up which project I best for investment
- Capital expenditure results in the acquisition of non-current assets or an improvement in their earning capacity.
- It is not charged as an expense in the statement of profit or loss; it appears as a non-current asset in the statement of financial position.
- Capital expenditure and income arising from it usually occur in different accounting periods, so special techniques are needed to evaluate it.
- The underlying motive is generally to assess the impact on shareholder wealth
Investment appraisal for Commercial organizations
Investment by commercial organizations might include investment in:
- Plant and machinery
- Research and development
- Advertising
- Warehouse facilities
Investment by the commercial sector is generally based on financial considerations alone.
Investment appraisal for Not For-profit organizations
Evaluation of investment by not for profit organizations is more challenging:
- Most not-for-profit organizations’ investments are not made with the intention of earning a financial return.
- As well as considering financial costs and financial benefits, social costs and social benefits are important.
- The cost of capital that is applied to project cash flows by the public sector will be
- one that is determined by the government.
Capital Rationing
It is a situation in which limited funds are available to invest in positive NPV Projects
Budget limits or constraints can arise from:
- Soft capital rationing, where constraints are imposed internally by management. ( Eg via a capital expenditure budget.)
- Hard capital rationing, where constraints are imposed by external factors,
- such as restrictions on the amount of external financing available.
Soft Capital Rationing Vs Hard Capital Rationing
Soft Capital Rationing | Hard Capital Rationing |
It is a situation in which limited funds are available to invest in a positive NPV project because of internal Factor’s | It is a situation in which limited funds are available to invest in a positive NPV project because of External Factors |
Management may be reluctant to issue further shares because of dilution in the control of existing shareholders. | The company can not raise further funds by issuing shares because stock prices are depressed in the stock exchange |
Management may be unwilling to issue further share because of dilution in EPS (Earning per share) | There may be a restriction on bank lending due to government controls |
The company has the policy to finance all new projects only from Retain Earnings. | The lending institution may consider your company too risky for further lending |
Management may not raise further debts because of fixed the commitment of interest payments | The cost of funds for arranging a new loan is too high |
Both types of constraints mean that investment has to be carefully planned to ensure the best use of funds.
Capital Budgeting Cycle
- Idea generation
- Project Screening
- Availability of funds
- Link to the strategic objective
- Government Rejection/Mandatory
- Financial Analysis
- Initial Method
Simple payback period
ARR - Advanced Method
NPV
Discounted Payback period
IRR
- Initial Method
- Non-Financial Analysis
- Political factors
- Ethical issues
- investment issues
- social issues
- Legal issues
- Approval (e.g From the board of directors)
- Implementation e.g Project Manager
- Ongoing Monitoring
- Post completion
Why Project screening – a qualitative analysis
- What is the purpose of the project?
- Does it ‘fit’ with the organization’s long-term objectives?
- Is it a mandatory investment eg to comply with laws?
- What resources are required eg money, labor?
- Do we have the necessary management expertise?
- Does the project expose the organization to high risk?
- How long will the project last?
- What factors are key to their success?
- Have all possible alternatives been considered?
Financial analysis during Investment appraisal
Will use the preferred investment appraisal techniques.
- What cash flows/profits arise from the project and when?
- Has inflation been considered in the estimates?
- What are the results of the financial appraisal?
- What risk analysis has been done and its results?
- How have non-tangible benefits been assessed?
Intangible costs and benefits during Investment appraisal
In addition to easily quantified financial benefits there might also be important intangible, non-quantifiable effects:
- Greater customer satisfaction (eg because of a computerized sales and delivery service).
- Better recognition because of an improved website.
- Improved staff morale from working with higher-quality assets or better systems.
- Better decision-making from better information systems.
Hard to quantify does not mean ‘not important’
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- Inflation
- Taxation
- Working capital
- Relevant/irrelevant cashflows
- Fixed appraisal horizon