Investment Appraisal

Investment appraisal

Investment appraisal is a technique by which a company evaluates the attractiveness of potential investments or projects based on the results of various capital budgeting and financing methodologies. It is a type of fundamental analysis for traders because it may assist discover long-term patterns as well as a company's perceived profitability.

When a company is involved in a number of long-term investment projects, there is a greater chance that revenues, costs, and cashflows would be negatively impacted. This is something that a trader should think about before investing in a company's stock.

Investment appraisal is significant for investors since it is an aspect of fundamental analysis that may demonstrate whether an investment or a company has long-term potential based on the profitability of its future initiatives and endeavours.

Investment appraisal is referred to as the techniques used by businesses and investors to determine whether or not an investment is viable.
Such involve assessing the viability and affordability of long-term initiatives, new goods, machinery, and so on.
Its approaches are classified as discounted or non-discounted.
Net present value (NPV), internal rate of return (IRR), profitability index (PI), and discounted payback period are examples of frequently applied discounted techniques. Non-discounted techniques, on the other hand, include the payback period and ARR.

Example:

The directors of XYZ Ltd are currently considering two mutually exclusive investment projects. Both projects are concerned with the purchase of new plants. In respect of each project, the following data are available. Calculate, Payback period, NPV, IRR and ARR.

Project 1 2

Cost /investment (1000) (600)

Expected annual net profit (loss)

Year 1 290 180

Year 2 (10) (20)

Year 3 20 40

Estimated residual value

70 60

Cash Flows Project -1

Y0 Y1 Y2 Y3

Investment -1000

Working capital 0

Net profit/loss 290 -10 20

Add: Depreciation 310 310 310

Cashflow from operation 600 300 330

Residual value: 70

Net Cashflows -1000 600 300 400

Payback period for Project -1

Payback Yr CF Cum CF

0 -1000 -1000

1 600 -400

2 300 -100

3 400 300

Payback within year 2 and

[{ (100 ÷ 400)= 0.25x12}] 3 month

depreciation project -1= {(1000-70)÷3}=310

Cash Flows Project -2

Y0 Y1 Y2 Y3

Investment - 600

Working capital 0

Net cash profit/loss 180 -20 40

Add: Depreciation 180 180 180

Cashflow from operation 360 160 220

Residual value: 60

Net Cashflows -600 360 160 280

Payback period for Project -2

Payback Yr CF Cum CF

0 -600 -600

1 360 -240

2 160 -80

3 280 200

Payback within year 2 and

[{ (80 ÷ 280)= 0.29x12}] 3 month

depreciation project -1= {(600-60)÷3}=180

Net Present Value for Project -1

Yr CF DF@10% PV@10%

0 - 1000 1.000 -1000

1 600 0.909 545.4

2 300 0.826 247.8

3 400 0.751 300.4

NPV 93.60

Net Present value for Project -2

Yr CF DF@10% PV@10%

0 -600 1.000 -600

1 360 0.909 327.24

2 160 0.826 132.16

3 280 0.751 210.28

NPV 69.68

IRR= R_1 + {NPV1 ÷(NPV_1 - NPV_2 ) } X (R_2 - R_1 )

Internal rate of return for project 1

YR CF DF@10% PV@10% DF@20% PV@20%

0 -1000 1.000 -1000 1.000 -1000

1 600 0.909 545.4 0.833 499.8

2 300 0.826 247.8 0.694 208.2

3 400 0.751 300.4 0.579 231.6

NPV 93.6 NPV -60.4

IRR= 10 + [(93.6) ÷ {(93.6-(-60.4)}] X (20-10) = 16.10 = 16%

Internal rate of returm for Project -2

YR CF DF@10% PV@10% DF@20% PV@20%

0 -600 1.000 -600 1.000 -600

1 360 0.909 327.24 0.833 299.88

2 160 0.826 132.16 0.694 111.04

3 280 0.751 210.28 0.579 162.12

NPV 69.68 NPV-26.96

IRR= 10 + [(69.68) ÷{(69.68-(-26.96)} X (20-10) = 17.21 = 17%

Average rate of return for project-1

Average Annual Profit = (Total profit)÷(Project Length)

= (290-10+20) ÷3 = 100

Average Investment = (Total Investment+Residual value) ÷2

= (1000+70) ÷2 = £535

ARR = 100 ÷535 = 0.019 or 19%

Average rate of return for project-2

Average Annual Profit = (Total profit)÷(Project Length)

= (180-20+40) ÷3 = 67

Average Investment = (Total Investment+Residual value) ÷2

= (600+60) ÷2 = £330

ARR = 67 ÷330 = 0.20 or 20%

Decision point

Analysis Project 1 Project 2

Payback 2 Year 3 Month 2 Year 3 Month

NPV 93.60 69.68

IRR 16% 17%

ARR 19% 20%