Introduction to Investment Appraisal Techniques

Firms throughout the world expand by starting projects and carrying out investments in different industries and sectors. An important building block in these investments is the analysis and later the evaluation of these projects on the basis of economic, cost and financial data. Investment appraisal techniques provide the financial data and also help managers determine the financial viability of each and every project under consideration. Concepts Related to Investment Appraisal MethodsAlmost all appraisal techniques are based on certain building blocks. These building blocks require estimations and forecasting of present data into the future. For instance future growth rates and interest rates need to be predicted in order to calculate the cost of capital for different projects. Similarly another important estimation is related to the cash inflows and cash outflows for a particular project. This requires the project evaluators or analysts to come up with accurate forecasts for sales , costs and other operating costs.Firms also need to look at the useful or life cycle of the project because that will determine the total net cash flows for a particular project, the time period will also tell the project evaluators about the time horizon of the project so that other economic and market factors could be considered as well while making the decision. Firms also need to plan the type of project evaluation techniques that must be used by the evaluators; for instance with projects that have a short-life span the Pay-Back method should be used to compare the speed with which each project is providing the initial investment.Many of the appraisal techniques must be used together to come to conclusions because of the way the data is presented to evaluators. For instance if a project is giving high returns in the later years but the overall average return is greater than another project that is giving high returns in the initial years than the evaluators might select the lat ter project because it is less risky. Important Investment Appraisal Techniques Pay-Back Period: This method simply calculates the time it will take a project to earn back the amount of money that was initially invested.This technique is extremely important in the comparison of those projects which have similar total life but varying cash flows throughout the life cycle. For instance in a scenario where interest rates are rising then evaluators would want to go for a project which has a lower Pay-Back period. This is because as interest rates increase the cost of capital will also increase and the real value of the returns will fall as we move into the future.Net-Present Value: This method discounts back all future cash-inflows and cash-outflows to the present values; the critical factor in this method is the determination of the discount/interest rate used to bring back the future values to the present. The important thing with this methodology is that it allows businesses to calcu late the real return that they will earn from the project i. e. businesses factor out the inflation or the nominal return that they might get from a project.Accounting Rate of Return: The ARR method provides the evaluators with a percentage that shows a return on the invested amount: say for instance if the ARR is 8% then the project is generating 8% returns annually on each dollar invested. This method does not discount the cash flows but it is helpful in the sense that it explains the potential of the project to generate enough cash flow so that a comparison can be made with other projects on an annual return basis. Internal Rate of Return: This method gives the evaluators with a percentage that shows the projects achieving net present value equal to zero.Essentially, the method calculates the rate at which the projects future calculated return (NPV) is equal to the initial invested amount. This method is extensively used by companies that plan on implementing large-scale projects . This rate gives evaluators an idea of what sorts of costs of capital is acceptable and at which levels or rates can we expect a profit. Value Addition from Appraisal Techniques The appraisal techniques discussed above are an extremely efficient way of substantiating projects and comparing the viability of different projects.The fact of the matter is that when firms want data for different projects while deciding which project to undertake they must objectively evaluate each project and the appraisal techniques provide an effective way of calculating financial data which can be used for analysis. Project Annual Net Cash flow Initial Investment Cost of Capital IRR NPV 1 ? 100,000 ? 449,400 14% A B 2 ? 70,000 C 14% 20% D 3 E ? 200,000 F 14% ? 35,624 4 G ? 300,000 12% H ? 39,000 Calculations for A, B, C, D, E, F, G, H The four projects have a useful life of 10 years. For project 1: Total Cash flow for 10 years: ?1,000,000. IRR: NPV= -? 449,400 + 100,000/ (1+R)1 + 100,000/(1+R)2 +†¦+ 100,000/(1+R)10 = 0. A = 18%; IRR = 18%. By using the trial and error technique we calculated the IRR to be 18%. NPV: -449,400/(1+0. 14)0 + 100,000/(1+0. 14)1 + 100,000/(1+0. 14)2 +†¦+100,000/(1+0. 14)10 = -449,400 + 521,611. 56 = 72,211. 56; B = 72,211. 56 For Project 2: IRR: NPV = -Initial Investment (C) + 70,000/(1+0. 2)1 + 70,000/(1+0. 2)2 +†¦+ 70,000/(1+0. 2)10 = 0; C = ? 293,474. NPV = -293,474/(1+0. 14)0 + 70,000/(1+0. 14)1 + 70,000/(1+0. 14)2 +†¦. + 70,000/(1+0. 14)10 = 71,655; D= ? 71,655For Project 3: Annual Net Cash Flow: IRR: NPV = -200,000 + E/(1+0. 14)1 + E/(1+0. 14)2 +†¦. + E/(1+0. 14)10 = 0; E = ? 38,343. Cost of Capital: 35,624 = -200,000 + 38,343/(1+F)1 + 38,343/(1+F)2 +†¦+ 38,343/(1+F)10 ; F = 11. 00% : through trial and error we calculated the value of cost of capital as 11. 00%. For Project 4: Annual Net Cash Flow: 39,000 = -300,000 + G/(1+0. 12)1 + G/(1. 12)2 +†¦. + G/(1. 12)10 ; G = ? 60,000; IRR (H): NPV= -? 300,000 + 60,000/ (1+R)1 + 60,000/(1+R)2 +†¦+ 60,000/(1+R)10 = 0. H = 15. 1%; by trial and error method we calculated the IRR of the 4th project as 15.1%. Project Selection Based on Available Data The investment techniques that have been used to evaluate the 4 projects have given us some important factors to consider before making the final decision. In light of the data available we suggest that project 3 should be chosen because firstly the initial investment is the lowest amongst all the four projects. Secondly another important factor is that the difference between the cost of capital and the IRR is less than some of the other projects more importantly the IRR is 14% which is the lowest amongst all the four projects.This means that if project 3 is pursued the company the is likely to achieve quick returns and even if the performance of the project is not outstanding due to external factors the company can make substantial returns from the project. The critical factor is that project 3 can b ring in returns far more quickly than other available projects as any returns beyond the 14% mark would be real returns on the investment. Another significant factor would be the saved money from the initial capital that can be used for other projects with similar or even better returns prospects.The cost of capital for this project is also the lowest amongst all other projects; this is also an indicator that change can be absorbed by the company. With project 3 we see that the annual cash flows are amongst the highest if we use the annual cash flow/ initial investment basis for comparison between all the four projects. This also indicates that project 3 is more viable than some of the other projects such as project 1. The only criticism of project 3 is that the gap between cost of capital and IRR is smaller than let’s say from project 1 or project 2.This creates a potential problem if and when interest rates start to increase then the project might become non-profitable in t erms of real rate of return. Conclusion The investment appraisal techniques have become an essential methodology to solve and answer critical questions when it comes to selecting major expansion projects. When companies go to venture capitalists or other financial institutions they must fulfill certain criteria before being given the amount of money they are looking for.Even in the investor industry most investors are required to provide there rate of return requirements before companies or other financial institutions could make tailored products for the investors. It must be emphasized here that companies must understand that other economic data is crucial in relation with the financial data that these appraisal techniques provide. Bibliography: The Institute of Chartered Accountants England and Wales, Investment Appraisal Techniques, viewed February 5, 2010 < http://financial. kaplan.co. uk/Documents/ICAEW/MI_Ch3_p. pdf> Schuster, Northcott, Gotze, 2008. Investment Appraisal: Met hods and Models, Springer-Verlag Berlin Heidelberg Martina Rohrich, 2007, Fundamentals of Investment Appraisal, Oldenbourg Coursework4you. co, Advantages and disadvantages of different appraisal techniques viewed February 5, 2010 < http://www. coursework4you. co. uk/essays-and-dissertations/finance-and-accounting/investment-appraisals/P_F_61_Advantages_and_disadvantages_of_different_investment_appraisals_techniques. php>Course Work 2 Introduction: The dynamics of any industry determine what factors will impact the demand and supply of a particular good or service being bought or sold in that particular market. Some of the major factors that affect the demand for most kinds of products or services include: consumer tastes, income levels, availability of substitute goods and their prices, availability and prices of complementary goods, future price expectations and the general level of literacy of the population and population growth.The other aspect of any market would be the supply side; how do the supply side factors impact the market for goods or services. For instance some major factors include technological advancements, cost of production, the number of suppliers and regulatory framework. A combination of these demand side and supply side factors determines the prices that markets ultimately charge from consumers given that the markets are allowed to function in a free market setting. Technology Market: In particular the Computer MarketWhen we discuss the computer market in isolation we must understand that it is affected greatly by the overall technology market which plays a critical role in determining which new products and services will be offered by these computers and how will these computers be manufactured in the future. Technology has revolutionized the way we do business and other activities around the world. A significant contribution of technological revolution is the machine we call: a computer. From the time of the first computers and up til l today we have witnessed remarkable change.For starters let’s just talk about the change in size of the computers. The point here is that ever since the advent of the computing machine and later the full fledged computer we have since tremendous amount of changes that have occurred along the revolution. These changes have had an impact on both the price of the computer and also on the cost of production of a modern day computer. Demand Side Factors The growth in different technology products such as hand held devices, laptops, desk top computers, I-pods, I-pads, E-books, and PDAs are some examples of what the consumer of today’s world has been buying and accepting for some time.The important factor here is that most technological products are not market oriented rather they are product-led or developed with a perspective of generating enough interest and demand from the market as opposed to the idea of providing products which are required by the market. The demand fo r computers in specific can be divided into two broad categories firstly the demand from the corporate world or offices and secondly from home users who demand desktops. When companies around the globe started to employ and use desktop computers in the 1980s and 1990s; one could see a revolution taking place that would forever change the workplace.These companies converted there existing manual operations on to computers and resultantly we saw dramatic changes in efficiency levels and the ability of companies to become more productive increased many folds. (Samuelson, 2005) This change in the way companies work led to computers becoming a need for majority of the companies in different sectors such as manufacturing, services and primary related industries. The computers, especially desktop computers had become a necessity for companies by mid-90s and onwards. This factor had made computers an important part of any firms capital requirements.(Samuelson, 2005) As far as the households were concerned computers soon after they were being mass-produced in the 80s become a necessity because of the change in the societal factors and requirements at workplace and schools demanded households to have computers at home. During these similar times (80s and 90s) income levels of the middle class households also increased on yearly basis. This was especially the case in the developing countries such as India, China and Brazil. The income levels were also rising in the developed countries which also warranted the increase in demand for computers.We saw that through the 1990s and 2000s the demand for complementary goods and services to the computers also increased. For instance the internet warranted the need for routers, wireless networks and other devices that were mandatory for office work and households. Similarly camera equipment that could connect them to PCs, mobile cables and other many products and services that were used in conjunction with the PCs were being increa singly demanded. We also saw the strength in the demand for substitutes and a consistent fall in their prices.For example a direct substitute of a computer is a handheld device which could be used for most of the purposes that a computer might offer. Even though these substitutes were available yet people ensured that they have at least one personal computer. This strength in demand is a result of the many features that a computer provides over some of its substitutes such as printing options, scanning, and video conference and so on. These added advantages and features have made computers an absolute necessity for the modern home.Another important factor that has played a critical role in increasing the demand for computers is the future expectations of technology and uncertainty. Because people feel that in the near future more emphasis will be given on efficiency and productivity it is imperative to keep up to date with the present technology. The combination of all these factors have created a scenario where by computers have become a part of the daily life of all individuals of the modern age. The internet has only helped the cause of the computers and we see that computers are an essential part of the workplace as well as the home of a particular individual.Supply-Side Factors The technological leap in the latter half of the last century has changed the way work takes place in a typical office of a manufacturing plant today. The reason is simple: the computer and technologies related to the computer. Not only have computers made it easier for companies to make products faster but they have also made companies more flexible and technology hungry. The supply of computers has been increasing at a great pace not only because of high demand but also due to technological changes that are taking place at all times.Between 1990 and 2002 there was a large decline in the prices of computer chips; this in part explains why computers prices were still falling even t hough demand continued to rise during that period. An important factor to understand here is that after the initial increases in the demand in the early 90s soon there was a surplus scenario in the chip market secondly, the rapid change in technology meant that older machines were quickly becoming obsolete hence pushing the prices even further down. (Lipsey and Chyrstal, 2007) Source: http://www.oup. com/uk/orc/bin/9780199286416/01student/interactive/lipsey_extra_ch03/page_01. htm In the diagram above we see that the prices of chips continued to fall between 1990 and 2002 except for the 92-95 period when the prices actually went up slightly the reason for the rise could be explained as the shift in the demand curve to the right as a result of the increase in the demand for complementary software that required high speed computer usage during this time; such as multimedia programs or other gaming and educational programs.The decline in the chip prices also explains the fact that cost of production was also declining rapidly during this time and that more and more suppliers of computers were entering the market. This increased competition for customers meant that prices had an even bigger drop. The increased competition also meant that firms that produce computers try to compete on cost as well as brand image. In an overall analysis of the supply-side of the computer and technology market we would say that prices have had a consistent downward pressure because of declining cost of production and a constant and rapid change in technology.There are a number of other important factors such as the availability of other important devices that have caused the prices of computers to fall down such as cheaper motherboards and RAMs. (Lipsey & Chrystal, 2007) Competition is also an important factor in determining the quality and prices of products such as computers. We see that competition has impacted cost of production by a large amount; many firms that manufacture comp uter and related devices have introduced more and better technologies that are cheaper and faster in processing data.In a lot of ways the market expects and demands computers which are cheaper and faster as we move into the future. This is because businesses and individuals know that computers are meant to reduce the time taken to complete work and achieve this objective in a cost effective way therefore more and more people and businesses demand cheaper computers. Market Scenario: Demand and Supply The market situation is such that the production of computers and the pace of technology have outpaced the overall growth in demand for computers.More importantly the increase in the demand for computers has been in phases when a shift in demand has caused a slight increase in computer prices. The decline in prices is also evident because of transfer of technology amongst different regions of the globe. Many of the developing countries have received technology and cheaper computers from the developed world which has further increased the process of better technological innovation and ever declining prices of computers.There is also a case of understanding that computers are a type of machine that must be renovated or renewed periodically therefore many companies are willing to sell them at lower prices knowing that costumers will buy new machines in the future and they will invest in newer technology. Therefore computer manufacturers have been pursuing brand holding strategies which includes selling computers to buyers at competitive rates.