Methods Used to Evaluate Investment Projects

systems Used to Evaluate Investment ProjectsEvaluation of the attractive feature of an enthronement proposal, using manners much(prenominal) as average deem of renovation, congenital rate of impart (IRR), net present value (NPV), or vengeance consequence. Investment appraisal is an integral part of capital budgeting (see capital budget), and is relevant to areas even w here the returns may not be easily quantifi able-bodied such as personnel, marketing, and training fair(a) Rate of Return (ARR) r enderingMethod of enthronement appraisal which determines return on investiture by tot completelying the notes in issues (over the years for which the money was invested) and dividing that amount of money by the number of years inner(a) Rate of Return (IRR) DefinitionOne of the two terminateed bullion hightail it (DCF) techniques (the other is net present value or NPV) partd in comparative appraisal of enthronement proposals where the flow of income varies over epoch. IRR is the average yearly return fooled through the life of an investment and is computed in some(prenominal)(prenominal) ways. Depending on the method used, it sewer either be the effective rate of interest on a deposit or loan, or the discount rate that reduces to zero the net present value of a menstruum of income inflows and outflows. If the IRR is higher than the desired rate of return on investment, then the start is a desirable one. except, it is a mechanical method (computed usually with a spreadsheet formula) and not a consistent principle. It can give wrong or misleading answers, especially where two mutually-exclusive controls are to be appraised. Also called dollar sign weighted rate of returnNet Present set (NPV) DefinitionNPV is the difference mingled with the present value (PV) of the future cash flows from an investment and the amount of investment. Present value of the expected cash flows is computed by discounting them at the indispensable rate of return ( in any case called minimum rate of return)For example, an investment of $1,000 today at 10 percent lead yield $1,100 at the end of the year in that respectfore, the present value of $1,100 at the desired rate of return (10 percent) is $1,000. The amount of investment ($1,000 in this example) is deducted from this figure to arrive at NPV which here is zero ($1,000-$1,000). A zero NPV means the barf repays original investment plus the required rate of return. A positive NPV means a better return, and a negative NPV means a worse return, than the return from zero NPV. It is one of the two discounted cash flow (DCF) techniques (the other is inner(a) rate of return) used in comparative appraisal of investment proposals where the flow of income varies over quantify retri justion Period DefinitionTime required to recover an investment or loan.INVESTMENT APPRAISALOne of the rouge areas of long-term decision-making that firms must(prenominal) tackle is that of investment the need to commit currency by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms confirm to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk inclined and the cost of obtaining funds.The main stages in the capital budgeting cycle can be summarised as followsForecasting investment needs.Identifying project(s) to meet needs.Appraising the alternatives.Selecting the high hat alternatives. make the pulmonary tuberculosis.Monitoring project(s).Looking at investment appraisal involves us in stage 3 and 4 of this cycle.We can classify capital expenditure projects into four broad categoriesMaintenance replacing old or obsolete assets for example.Profitability quality, productivity or location improvement for example.Expansion radical products, markets and so on.Indirect social and welfare facilities .Even the projects that are flimsy to generate profits should be subjected to investment appraisal. This should help to identify the best way of achieving the projects aims. So investment appraisal may help to distinguish the cheapest way to provide a new staff restaurant, even though such a project may be unlikely to earn profits for the company.Investment appraisal methodsOne of the most important stairs in the capital budgeting cycle is working out if the benefits of investing bad capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised one of two ways traditional methods and discounted cash flow techniques. Traditional methods include the intermediate Rate of Return (ARR) and the vengeance method discounted cash flow (DCF) methods use Net Present Value (NPV) and Internal Rate of Return techniques.Traditional MethodsPaybackThis is literally the amount of time required for the cash inflows from a capital inve stment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period. Payback is often used as an initial screening method.Payback period = Initial payment / Annual cash inflowSo, if 4 gazillion is invested with the aim of earning 500 000 per year (net cash earnings), the payback period is deliberate thusP = 4 000 000 / 500 000 = 8 yearsThis all looks fairly easy But what if the project has more uneven cash inflows? Then we need to work out the payback period on the cumulative cash flow over the duration of the project as a whole.Payback with uneven cash flowsOf course, in the real world, investment projects by business organisations dont yield even cash flows. Have a look at the following projects cash flows (with an initial investment in year 0 of 4 000)The payback period is precisely 5 years.The shorter the payback period, the better the investment, under the p ayback method. We can appreciate the problems of this method when we consider appraising several projects alongside each other.But, here we must face the real problem posed by payback the time value of income flows.Put simply, this issue relates to the sacrifice made as a result of having to wait to receive the funds. In economic terms, this is known as the opportunity cost. More on this point follows later.So, because there is a time value constraint here, the payback method can become complicated. In this case, the earlier flow of revenue enhancement is a key factor. Also if post-payback revenues surpass earlier in the lives of competing projects, that can be a decisive factor.OK, so its clear that the payback method is a bit of a point-blank instrument. So why use it?Arguments in favour of paybackFirstly, it is everyday because of its simplicity. Research over the years has shown that UK firms favour it and perhaps this is understandable minded(p) how easy it is to calculat e.Secondly, in a business environment of rapid technical change, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential.Thirdly, the investment climate in the UK in particular, demands that investors are rewarded with fast returns. Many utile opportunities for long-term investment are overlooked because they involve a lifelong wait for revenues to flow.Arguments against paybackIt lacks objectivity. Who go downs the length of optimal payback time? No one does it is decided by pitting one investment opportunity against another.Cash flows are regarded as either pre-payback or post-payback , but the latter(prenominal) tend to be ignored.Payback takes no account of the effect on business profitability. Its sole concern is cash flow.Payback summaryIt is believably best to regard payback as one of the first methods you use to assess competing projects. It could be used as an initial screening tool, but it is inappropriate as a basis for sophisticated investment decisions.Average Rate of ReturnThe average rate of return expresses the profits arising from a project as a percentage of the initial capital cost. However the definition of profits and capital cost are different depending on which textbook you use. For instance, the profits may be taken to include depreciation, or they may not. One of the most common approaches is as followsARR = (Average annual revenue / Initial capital costs) * 100Lets use this simple example to expatiate the ARRA project to replace an item of machinery is being appraised. The machine will cost 240 000 and is expected to generate total revenues of 45 000 over the projects five dollar bill year life. What is the ARR for this project?ARR = (45 000 / 5) / 240 000 * 100 = (9 000) / 240 000 * 100 = 3.75%Advantages of ARRAs with the Payback method, the chief advantage with ARR is its simplicity. This makes it relatively easy to understand. There is also a link with some expl anation measures that are commonly used. The Average Rate of Return is similar to the Return on Capital utilise in its construction this may make the ARR easier for business planners to understand. The ARR is expressed in percentage terms and this, again, may make it easier for managers to use.There are several criticisms of ARR which raise questions about its practical applicationArguments against ARRFirstly, the ARR doesnt take account of the project duration or the timing of cash flows over the course of the project.Secondly, the thought of profit can be very subjective, varying with specific accounting practice and the capitalisation of project costs. As a result, the ARR calculation for equivalent projects would be likely to result in different outcomes from business to business.Thirdly, there is no definitive signal given by the ARR to help managers decide whether or not to invest. This lack of a guide for decision making means that investment decisions remain subjective.