Capital Investment Appraisal

Tags

finance

Appraising the viability and practicality of an Investment opportunity.

When deciding on an investment a firm must consider: risk & uncertainty, monetary returns and non-monetary business objectives.

Opportunity cost of an investment is the minimum expected return (or yield) of the investment.

Appraisal Techniques

Accounting rate of return

Is the [see page 9, ratio] of \(\frac{Average Expected Return}{Averge Captial Employed/Investment}\). The AER is the total cash flow over the investment period divided by the investment duration (we don't consider the initial investment or scrap returns). The ACE/I is the average of the sum of the initial and final value of the investment.

See [see page 10, advantages & disadvantages].

Payback period

Is how [see page 11, long] it takes an initial investment to be repaid out of the net cashflow from a project. Note: payback period can be as granular as required (essentially just the first date where total cost is \(\gt\) than 0).

See [see page 15, advantages & disadvantages].

Net present value

Present value of the net cash flows subtracting the projects initial investment. If this value is positive then the project should be accepted.

We define:

• cost of capital - cash return organisation can receive if they invest in securities over some other less risky project. AKA. opportunity cost of investment, minimum amount of return and interest rate.
• discount-rate factor - \(\frac{1}{cost of capital ^ {year}}\).

See [see page 21, examples]. We basically multiply the year profit by the discount factor for that year over \(n\) years and only perform the assessment when the sum of these values exceeds our initial investment. Note: Higher net present value takes precedence.

See [see page 25, advantages & disadvantages].

Internal rate of return

Find the discount [see page 26, rate] for which the net-present-value sums to 0 at the end of an investment period. We use this value compared to other investments to determine the feasibility of an investment.

Note: Net present value takes precedence over Internal rate of return if there's a conflict.

[see page 30, Works] by using a discount rate leading to a negative rate of return and a discount rate leading to a positive rate of return. It then linearly interpolates between the two to reach an IRR.