Capital investment Appraisal
Business expenditures for acquiring assets to be used for more than one year are called capital investments. Examples may include investment in properties, plant, equipment, vehicles, research and development projects and other non-current assets. The ultimate objective for making capital expenditure or investment is to improve or maintain the overall profitability and net worth of the enterprise over the long run.
The selection of long term projects or making capital investment decisions is one of the vital areas of long-term decision making. In an ideal world, organisations should go for all projects and prospects that add value to the business. However as businesses have limited financial resources so capital investment appraisal techniques are used to help in the selection of proper projects to yield optimum returns i.e. benefits from capital investment outweigh their costs.
The capital investment methods can be classified as discounting and non-discounting techniques. Discounting cash flow methods include Net Present Value and Internal Rate of Return whereas non-discounting methods include the Payback method and the Accounting Rate of Return (ARR).
Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques. Accept the project only if it’s payback period is LESS than the target payback period.
Accounting Rate of Return (ARR)
Accounting rate of return is the ratio of estimated accounting profit of a project to the average investment made in the project. Average accounting profit is income expected to be earned during each year of the project's life time. Accept the project with highest ARR.
Accounting Rate of Return is calculated using the following formula:
(Total Cash Flows - Accumulated Depreciation)/ No of years
(Total Receipts – Total Payments – Total Depreciation) / No of Years
Annual Revenue - Annual Expenditure - Annual Depreciation
Initial Investment / 2
Initial Investment - Scrap/Residual Value
+ Working Capital
Net Present Value (NPV)
Net present value (NPV) is a discounted technique where estimated cash flows must be converted into present value. NPV of a project is the potential change in an investor's wealth caused by that project while time value of money is being accounted for. It equals the present value of net cash inflows generated by a project less the initial investment on the project. It is one of the most reliable measures used in capital budgeting because it accounts for time value of money . In case of mutually exclusive projects (i.e. competing projects), accept the project with higher NPV.
Internal Rate of Return (IRR)
Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. In other words, it is the discount rate which equates the present value of the future cash flows of an investment with the initial investment. A project should only be accepted if its IRR is NOT less than the target internal rate of return. When comparing two or more mutually exclusive projects, the project having highest value of IRR should be accepted.
IRR = A + ( B * C/D )
A = Rate of +ve NPV
B = Difference in Rate
C = +ve NPV
D = Difference between NPV