What is investment appraisal?
In layman terms, investment appraisal is the process of finding out whether an investment is worth undertaking. It involves establishing the benefits arising from the investment will exceed the costs and resources spent on the venture. Synonyms used to refer for investment appraisal are “capital budgeting”, “project appraisal” and “investment evaluation”. In the context of this article, an investment means an acquisition of a business asset or a group of assets for income generation purposes.
The same concept can also be utilised to evaluate the purchase of shares and similar securities. Other forms of investments by companies include the establishment of new product lines, Research, and Development (R&D), entering into new markets/outlets, mergers, and acquisitions of other businesses.
Why conduct investment appraisal?
It is essential to conduct an assessment to find the worth of an investment before committing resources for the below reasons:
- Financial and human resources are scarce; generally, they have competing needs. It is vital to make the best choice to utilise the resources at an optimum level. Whenever there are competing ventures, careful analysis should be done to determine the best alternative.
- The amount of investment needed is usually very large at the inception of the venture with possible additions during the life of the investment.
- Profits expected are committed before the start of the project in the form of returns or rewards spread over a long period of time, for example, five years or more. Funds are invested for long periods and there is an opportunity cost of deploying the funds in the projects.
- A significant level of risk is involved due to the uncertain future. Investment appraisal is part of the processes of risk assessment and it shows that the organisation is taking “calculated risks”.
- Investment appraisal is part of budgeting and it is the basis for performance appraisal against the strategic objectives of the entity.
Factors to consider in investment appraisal
Apart from cash flow analysis and profits expected from an investment, the following variables should be analysed as they have an impact on the outcome of the investment.
- Cost of funds: Generally referred to as “cost of capital”. This cost represents the interest on external borrowed funds or opportunity cost of funds in the case of internally generated funds. We also refer to the cost of funds as Finance Cost.
- Project duration: Capital projects involve tying up funds for periods more than one financial year. The project duration becomes a key aspect to consider in the investment decision. The concept of Time Value of Money, is a notion that an amount of money receivable today is more worth than the same amount receivable in future.
- Risk: There is a probability that actual returns from an investment would differ from the expected returns. Risk consideration must be part of the investment decision and the level of risk considered depends on the risk appetite of the organisation.
- Other external factors such as inflation and taxation.
How investment decisions are made
Investment decisions involve comparing the cost of investment and the expected returns. For an investment to be beneficial, the expected returns must be greater than the cost of the investment. There are various methods used in the evaluation of investments. Few methods are based on cash flows while others are based on profits. One more important thing is investment decisions are not taken exclusively on financial grounds. Non-financial factors are also considered before deciding whether to invest or not.