capital rationing

Investment appraisal

investment appraisal ACCA FM

Investment appraisal is a number of methods used to classify the attractiveness of an investment.

Investment appraisal ACCA
Investment appraisal ACCA Financial Management ACCA

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

  1. Idea generation
  2. Project Screening
    • Availability of funds
    • Link to the strategic objective
    • Government Rejection/Mandatory
  3. Financial Analysis
    • Initial Method
      Simple payback period
      ARR
    • Advanced Method
      NPV
      Discounted Payback period
      IRR
  4. Non-Financial Analysis
    • Political factors
    • Ethical issues
    • investment issues
    • social issues
    • Legal issues
  5. Approval (e.g From the board of directors)
  6. Implementation e.g Project Manager
  7. Ongoing Monitoring
  8. 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.

  1. What cash flows/profits arise from the project and when?
  2. Has inflation been considered in the estimates?
  3. What are the results of the financial appraisal?
  4. What risk analysis has been done and its results?
  5. 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
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