Project Investment Appraisal

Before walking towards the concept of project management, It is vital to first choose a project which is viable to be carried out. The importance of analyzing the viability is due to the large sums of investments made by companies and through sponsorship for the initiation and implementation of a project.

A project that would result in a less cash flow generation or that would take unacceptable time periods to return the investments are not viable to be initiated as the cost incurred maoy not be worth it in comparison with time value of money or if it may not be recovered in a profitable manner.

To mitigate the risk of the loss of investment, various financial calculations and techniques are introduced. Calculations done to check the viability of the projects is usually called as "Project Option Analysis" and is commonly known as "Investment Appraisal"

The techniques used to appraise investments are as follows ;

•  Discounted cash flows (DCF) 
•  Return on capital employed (ROCE)
•  Cash Flow Return on Investment (CFROI)
•  Adjusted Present Value (APV) 
•  Economic Value Added (EVA)
•  Internal Rate return (IRR)
•  Payback period
•  Net present Value (NPV)
•  Accounting rate of return (ARR)
•  Decision Tree Analysis (DTS)
• Present Value Factor (PV)

 Each of these technique has its own advantages and disadvantages. 

According to rdi.usa.com (2012), the four most commonly used techniques for appraising capital investment projects are ;

1. Payback Period
2. Accounting Rate of Return
3. Net Present Value
4. Internal Rate of Return

Two of the techniques learnt are as below;

Payback Period Analysis

Payback period is often used as a "First screening method". As stated in  rdi.usa.com, payback method is a calculation that is easy and simple to understand and favours projects that recover investments as quickly as possible. The calculation would be useful in projects where the investment return is needed quickly. The calculation is as follows;

Figure 04 : Payback Period Calculation

According to the calculations, the longer the payback period, higher the investment risk is and longer the capital is tied up. The shorter the better.

Financial.kaplan.co.uk (2012), lists down the advantages and disadvantages of Payback period as follows;

Advantages

• Focus on early payback where liquidity can be enhanced
• Quick and simple calculations
• Easily understood concept 

Disadvantages

• Ignores the timing of cash flows
• Ignores the time value of money
• May lead to excessive investment in short-term projects
• Unable to distinguish between projects with the same payback period.

Net Present Value 

As depicted by Pogue (2010), the use of NPV method provides a solution in monetary terms. The calculations are consistent with the objective of maximizing the shareholder wealth, as positive NPV should yield an equivalent increase in shareholder wealth. In the calculation, all cash flows related to the project are calculated in to present values.

Figure 05 : NPV Calculation

I     = Investment

CF = Cash Flow

r     = Rate of return

n    = Number of Years

If the NPV is;

NPV > 0     = Project Viable (Accept)

NPV < 0     = Project Not Viable (Reject)

NPV = 0     = Project Viable (Accept)

As per Financial.kaplan.co.uk (2012) and Pogue (2010), The advantages and disadvantages of Using NPV to analysis project viability are;

Advantages 

• Considers the time value of money
• Considers all cash flows
• Provides a clear, unambiguous decisions

Disadvantages

• Requirement of an estimate on discount rate and investment
• Difficult to interpret as the value is  shown in monetary terms and not in percentages
• Do not allow flexibility after the project decision

References

financial.kaplan.co.uk, 2012. Investment Appraisal Techniques. [Online] Available at: http://financial.kaplan.co.uk/Documents/ICAEW/MI_Ch3_p.pdf [Accessed 8 August 2012].

Pogue, M., 2010. Corporate Investment Decisions : Principals and Practice. New York: Business Expert Press.

rdi-usa.com, 2012. Investment Appraisal. [Online] Available at: http://www.rdi-usa.com/pdf/BABusinessManagement.PDF [Accessed 05 August 2012].