Investment Appraisal Techniques

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Critical Analysis of Pros and Cons:

Advantages

Disadvantages

Easy to comprehend and simple to compute (Ross, 2006) (Treasury Today, 2004)

Does not consider the concept of discounting and fails to consider timing or consistency of cash flows (BUSINESSESSAYS.NET, n.d.)

Does not require any specific information or reports as it is simply based on profits

(Ross, 2006) (Treasury Today, 2004)

Based on accounting income (includes non-cash charges which include depreciation and amortization) and cash flows & market values (BUSINESSESSAYS.NET, n.d.)

Application Scenario:

- Not suitable for evaluation of a new project since it uses historical information of profits (Pike & Neale, 2006). It also segregates individual projects and does not consider the overall systematic impact of the project on the entire organization. ( Investopedia, LLC, n.d.) In addition, it is also not an ideal measure for comparison since financial measurement and accounting methods for different project may not be consistent with each other. ( Investopedia, LLC, n.d.)

Discounted Cash Flow Techniques: (UKESSAYS.COM, 2017)

- Net Present Value also known as Discounted Cash Flow Method (NPV): (UKESSAYS.COM, 2017)

Discounted Cash Flow method or Net Present Value is the primary and most dominant investment appraisal technique. It is used to evaluate various investment options and provides the investor, an estimate of the cumulative wealth the project assures. It is equal to the net cash flow’s present value in the future time period and is discounted at an estimated cost of capital. (Brigham & Ehrhardt, 2013)

An investment has essentially two key elements:

- Assets whose value depreciates over time. The return on Assets should not only cover the initial investment but should also provide a yield as per the investor’s expectations.

- Investments are generally long term ranging from 1-30 years thus making it important that the phenomenon of time value of money is also factored In. (Brigham & Ehrhardt, 2013)

Decision Rule:

NPV = 0 – Indifferent about accepting or rejecting the project (Ross, 2006)

NPV > 0 – Participate (Project improves value) (Ross, 2006)

NPV

For projects where only one can be chosen from all the options, the project with highest Net Present Value should be considered (Ross, 2006)

Critical Analysis of Pros and Cons:

Advantages

Disadvantages

Considers the concept of discounting and all the project cash flows (UKESSAYS.COM, 2017)

Requires a cost of capital also known as discount rate or interest rate for discounting which is difficult to estimate. (Drake, n.d.) (Treasury Today, 2004)

Considers the potential risk of future cash flows as well by discounting through a cost of capital (UKESSAYS.COM, 2017)

Estimated in monetary term (in dollars) and not in terms of percentage making it difficult for comparison (Drake, n.d.) (Treasury Today, 2004) (Knowledge Grab, n.d.)

Uses cash flows rather than profits to determine profitability (Drake, n.d.) (Treasury Today, 2004) (Knowledge Grab, n.d.)

Can involve complex calculations and fails to consider timing of cash flows (Drake, n.d.) (Treasury Today, 2004) (Knowledge Grab, n.d.)

Application Scenario:

- NPV Method is not very effective for projects with different effective lives or projects with distinct size and scale (Knowledge Grab, n.d.)

- Also, not very applicable in scenarios where quick results are required as the method is time consuming and involves detailed calculations (The Student Room, 2017)

- Internal Rate of Return (IRR):

Internal Rate of Return IRR is simply the discount or interest rate at which project NPV = 0 (Pike & Neale, 2006) It can also be defined as the geometric average return on a project. (CFA Institute, 2017) It is the second most preferred method after NPV and is true interest yield promised by an investment over its useful life. (Damodaran, 2001)

Decision Rule:

IRR > Minimum Required Rate of Return - Invest (Project improves value) (CFA Institute, 2017)

IRR = Minimum Required Rate of Return – Project gives no value (CFA Institute, 2017)

IRR

Critical Analysis of Pros and Cons:

Advantages

Disadvantages

Based on percentage return rate and considers time value of money (Drake, n.d.), (CFA Institute, 2017)

Calculated iteratively and can be accurately calculated through financial calculator or a computer (Drake, n.d.), (CFA Institute, 2017)

Considers the risk of the project. Easy to visualize and interpret and considers the entire life of the project (Drake, n.d.), (CFA Institute, 2017)

Non-conventional cash flows give multiple IRRs and can result in incorrect evaluation (Drake, n.d.), (CFA Institute, 2017)

Application Scenario:

- IRR method is not very useful when one has to consider between projects when there is capital rationing. (UKESSAYS.COM, 2017) It can also not be applied in scenarios where sign of project Cash Flows change more than once in the entire project life. (Drake, n.d.)

- Discounted Payback Method:

Discounted Payback Method is a modified form of Payback method. (UKESSAYS.COM, 2017) It is defined as the total amount of time taken