Investment Appraisal should Add Value to Business Entity

Successful companies are always keen to develop and grow by investing in the new projects to sustain and maintain their strategic position in the competitive market. Therefore companies always adopt strategic planning approach also known as corporate planning for long-term which in result gives direction to the company. One of the key areas in Strategic planning is strategic decision making by the senior management, to manage the available funds by the firm , right choice of investments by using strategic analysis approach and considering whether the options meet and are consistent with the firm's objectives and are acceptable to main stakeholders.

Financial Management analyse their available options of investments by focusing on the size of the funds need to commit to purchase lands, buildings etc, expected inflows and outflows in the future, life span of the investment and degree of risk involved in the investment. Then the management select the best possible options which are economical and profitable for the firm. This approach is known as investment appraisal. The investment appraisal process is concerned with assessing the value of future cash flows compared to cost of investment.

The above discussed investment appraisal approach also contributes and on the following aspects of the business.

Replacing the obsolete assets with newly developed assets.

Enhancement of current products and development of new products.

Increase in existing market share and introduction of new markets.

Objective based fair decision making by analysing all possible alternatives

Investments in profitable projects which adds value to the business.

Realistic budgeting and cash flow forecasting.

Considers risk involved in the projects.

Therefore it can be clearly seen that Investment Appraisal approach in decision making also adds value to the Business along with selecting the most economical and profitable choices for the business in long term.

As indication from the above results of IRR, Project A would be accepted by project manager and potential investors. In both projects, cost of capital is same i.e. 12.5% but IRR of project A is 14.96% compare to 13.51% of project B. As per general rule, if resulted IRR is more than the interest rate then it should be acceptable but in our given scenario we will invest in project A because it has more difference between IRR and its cost of capital compare to project B.

Discounted cash flow analysis is a procedure whereby the value of future cash flows are discounted back to present values using the discounted rate based on the cost of the capital available for the project, so that the economic values of future cash flows are comparable despite of timing difference. In the dearth of discounted future cash flows, resulted NPV and IRR will not appraise the project in real term and will not reflect the true picture of the investment appraisal.

The key idea behind is that the value of money decline over time period due to the impact of inflation factor in eroding spending power. Investors normally like to receive their money back as soon as possible because it creates opportunities to invest new and upcoming ventures. In contrast, short term investment for instance the project for the year or less, the cash flows do not need to discount back and not require dealing with inflation .It is therefore essential to discount the cash flow so the impact of inflation and taxation on cash flows can be incorporated in projecting long term investments.

The Net Present Value uses discounting to compute the present value of all future cash flows linked with the project The Net Present Value rely on the cash flow pattern and cost of capital which is applied. Any changes in the cash flows or in cost of capital will directly affect the resulted NPV and therefore project implementation as well. If cash flows are stagnant and cost of capital is variable then NPV will be indirectly proportional to the cost of capital.

. If cost of capital increases, it affects discount factor and present value of future cash flows will decrease resulting lower NPV until reaches to negative NPV in which case investment of project will be rejected. If the cost of capital decreases then NPV will increase as can be seen in the following illustration on given date of Project B.

One of the drawbacks of using NPV as capital budgeting specially for long term project is to accurately calculate discount rate for the project life. The NPV based on the estimated future cash flows which are to be discounted back to their present value by using discount rates whereas investments do not need to discounted because of time 0 .Also during calculating NPV of the project there can be multiple key variables which would be sensitive and the smallest changes produces the biggest results in project NPV.

In reality project may have several variables which can be affected the resulted NPV and are sensitive for the project but if we concentrate and observe only the discount rate in isolation we can find that even minor change in discount rate can either adversely affect or improve the resulted NPV of the project. Therefore to select an appropriate interest rate is quite significant

In the above table, we can observe as discount rates changes from 10% to 15%, the resulted NPV also changes from positive £2,414 to negative £1,010 which will not be acceptable to investors. The interest rate used for discounted should be equal to required rate of return which means that if investments would have invest to best available project or lower cost of financing .To establish effective and stable discount rate for long term projects hardly is an exact science.

In real term discount rate may vary every year or even change during the year due to inflation and risk. In short term projects, inflation and risk factors do not affect a lot to interest rate comparatively in long term projects where these can affect the interest rate for each year. If we incorporate the different discount rates for each year this made NPV more complex model so lower rate of interest would be more appropriate to the extent that a long term project implies secure income stream.

IRR uses discounting in a slightly different way to determine the profitability of an investment. The IRR is defined as the discount rate at which NPV value equals zero. For example in Project B, an investment yields net present value of £694 when discounted as 12.5 %. When we reduced the rate of interest to 10% then the resulted NPV rise to £2,414 and IRR was 13.51% which depicts the efficient and break even interest rate for the investment. As per general rule, IRR should be more than the discount rate then the company should invest in the project.

There are different approaches in capital budgeting which can be used which can used investment appraisal. NPV and IRR are most popular approaches and two faces of same coin and but there are some key limitations in both approaches.

The investment on the project is accepted if NPV is greater than zero after ranking NPVs of all the projects and normally provide clear indication whether to accept or reject the project whereas IRR is accepted if it is greater than cost of capital, both approaches gives different results.

NPV gives result in real term means in currency whereas IRR is represented in percentage which is easy for project managers to compare with required rate of return , interest rare and inflation rate. IRR percentage can also use for managerial appraisal during divisional performance.

Research also shows that NPV approach is preferred to IRR because it also incorporates and calculates additional wealth which IRR does not cover.

IRR also does not give the freedom to discount the cash flows at different discount rates which is possible in the case of NPV method.

If cash flows are fluctuating and inconsistent, IRR does not seems to be conclusively applicable in these circumstances where as NPV method would pose no challenge to this problem as it will take the net effect of all cash outflow and inflow and will provide the average return of the investment

NPV and IRR both are difficult in the context of to estimate the accurate discount rate to use. This leads problem towards risk premium which affect the riskiness of the project. Therefore alternative approaches of investment appraisal should also be considered like sensitivity analysis, profit.

In small projects Net Present Value and IRR does not generally employed. Normally projects involves variety of risks and different methods are used which gives better understating regarding the returns of investments and practical benefits of IRR and NPV calls into question and put some practical limitation in use of these methods.

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