Capital investment appraisal, also known as capital budgeting is primarily a planning process which facilitates the determination of the concerned firm’s investments, both long term and short term. The components of the firm that come under this kind of capital investment appraisal include property, equipment, R & D projects, advertising campaigns, new plants, new machinery etc. Thus in simple words, capital investment appraisal is the budgeting of major capital and investment to company expenditure. For example, capital investment appraisal in small companies decides on future ventures into newer markets as well as expansion and inclusion of new activities.
Capital investment appraisal factors are selected based on the priorities of stakeholders and decision makers. This available wide criteria selection of capital investment appraisal or budgeting is based upon long term growth when compared to short term profits. In order to get a fuller picture and better understanding of capital investment appraisal, various capital investment appraisal techniques are employed to measure capital investment appraisal of a company.
Ten Capital Investment Appraisal Techniques
The capital investment appraisal techniques used to measure capital investment appraisal of a business project include:
- Net present value
- Accounting rate of return
- Internal rate of return
- Modified internal rate of return
- Adjusted present value
- Profitability index
- Equivalent annuity
- Pay back period
- Discounted pay back period
- Real option analysis
Net Present Value (NPV) – this capital investment appraisal technique measures the cash in-flow, whether excess or shortfall, after the routine finance commitments are met with. All capital investment appraisals have a single objective – drive towards a positive NPV. The NPV is a mathematical calculation involving net cash flow at a particular present time ‘t’ at discount rate at the same time, i.e. (t – initial capital outlay). Thus there is an inverse proportional relation between discount rate and NPV. A high discount rate would reduce the net present value of capital. A high interest rate increases discount rates over a period of time and most capital investment appraisals are wary of such an increase.
Accounting Rate of Return (ARR) – this capital investment appraisal technique compares the profit that can be earned by the concerned project to the amount of initial investment capital that would be required for the project. Projects that can earn a higher rate of return is naturally preferred over ones with low rate of return. ARR is a non discounted capital investment appraisal technique in that it does not take into consideration the time value of money involved.
Internal Rate of Return (IRR) – capital investment appraisal techniques define IRR as discount rate that gives a value of zero to NPV or net present value. Among all capital investment appraisal techniques, IRR is generally considered to measure the efficiency of the capital investment. Thus, if cost of capital investment in company works out to be greater than the IRR value, the project is highly likely to be rejected. On the other hand, a low cost of capital has more chances of being accepted. IRR is calculated by equating NPV to zero and then deriving the discount rate. Even though IRR and NPV are related capital investment appraisal techniques they are different from each other. IRR considers the time value of money over the project life time and derives the world discount rate.
Modified Internal Rate of Return (MIRR) – the IRR does not give the actual annual profitability of a capital investment since it does not take into consideration the intermediate cash flows which is never reinvested equalling project IRR. Hence the IRR capital investment appraisal technique is not effective enough since the rate of return in actual is certainly going to be lower. This flaw is over come by a more efficient capital investment appraisal technique – MIRR. MIRR evaluates capital investment projects assuming that reinvestment rate equals the company’s cost of capital.
Adjusted Present Value (APV) – APV capital investment appraisal technique overcomes the shortcomings of NPV technique and evaluates a project on the basis of risks associated to prospective company undertaking the investment.
Profitability Index (PI) – evaluates a project based on calculation of value per unit of investment. Also known as value investment ratio and profit investment ration, this capital investment appraisal technique is a ratio of amount of money invested to profit or pay off of the project.
Equivalent Annuity – capital investment appraisals done using equivalent annuity usually compares projects with different life spans. In cases where two projects have different time spans, NPV would not justify a fair comparison. This capital investment appraisal technique divides the NPV value with annuity factor resulting in expressing NPV in relation to annualized cash flow.
Payback Period – appraising capital investment on the basis of time that would be taken to get back your initial investment is called as payback period. Payback period is one of the easiest methods of capital investment appraisal techniques. Projects with a shorter pay back period are usually preferred for investment when compared to ones with longer pay back periods.
Discounted Payback Period – capital investment appraisals using discounted payback period is similar to payback period but here, the time value of money or discounted value of cash flow is considered for calculation of payback period.
Real Option Analysis – capital investment appraisals using real option analysis considers and values the various options that managers would have while managing their projects in terms of increasing cash in flow ans decreasing cash out flow. These values are added to NPV in the course of capital investment appraisals.
All the above mentioned capital investment appraisal techniques are used for ranking projects. Usually, organizations have many projects that are appraised simultaneously for financial viability. Once the preliminary appraisal of a project is completed, it is compared and ranked against other peer projects. The projects in consideration are ranked from having high Profitability index to lowest Profitability index. The higher ranking projects are usually implemented after careful and detailed due diligence.