Investment appraisal

In economics, the notion of investment refers to the flow of resources into production of new capital (net additions in stock, plant and machinery and construction). In finance and business contexts, the term investment is used more widely to refer to any new activity ("investment project") to which an enterprise can commit its resources in anticipation of rewards. More broadly, investment may be defined as 'an activity for which the required outlays and the benefits are not expected to be concurrent'. This notion stresses the importance of the investment horizon, or the time period over which the rewards of investment are expected. As this section shows, this will be a critical factor in many methodologies dealing with the selection of investment projects.

Investment projects (or opportunities) vary considerably in nature. Appraisal techniques are needed to help managers or investors make sound decisions and select the best projects. The list below categorizes different types of investment activities to which investment appraisal may be applied

  • expansion - establishing the viability of expanding existing product lines
  • diversification - appraising the soundness of investment into new products and services
  • cost saving - investment activities that are expected to result in cost savings (e.g. production automation),
  • replacement - not all investment decisions result in net additions to the capital stock, so deciding whether and when to replace existing equipment constitutes another type of consideration in investment appraisal
  • research & development - this can affect enterprise productivity, competitive position and, financial performance;
  • alternative choice - this type of investment decision requires choosing between alternatives which achieve the same objectives
  • financing - comparison of the benefits of purchasing an asset against leasing it
  • others - such as expenditure on complying with health and safety standards, e.g.. a pollution control device

The essence of all investment appraisal is the assessment of the worthiness of proposals which require economic and financial resource commitments, by taking account of their benefits and costs. For a company, bad investment decisions can result in poor economic and financial performance, limited future growth, loss of opportunities to attract new investors or the dis-satisfaction of existing shareholders.

It may be noted that the appraisal of investment is an aspect of the wider process of financial decision making; the other being financing (capital structure) and dividend decisions. Investment decisions are important because they determine the total amount of assets held by companies, the composition of these assets and the business risk makeup of the companies as perceived by investors. Thus, future viability of an enterprise can depend on its present investment decisions. These decisions also set the context in which financing and dividend decisions are made.

The significance and particular position of investment appraisal may be better appreciated by considering the broad functions of financial management as follows

  • converting a business plan into a financial plan
  • appraising the viability and suitability of the financial plan in the light of the company's objectives
  • the choice of financing with respect to the plan
  • controlling the plan's implementation
  • presenting the result and outcome of the plan to interested parties (e.g. the directors and shareholders)

Investment appraisal intercedes between the stage where a business plan is translated into its equivalent financial plan and the decision to finance its implementation. Evaluation of the alternatives and viability of a financial plan involves a careful study of its components, alternatives, costs and benefits associated with it.

Finally, much investment decision making takes place in circumstances ridden by risk and uncertainty (even unknowns). Conjectures about future benefits (as measured by cash flows) are often no more than guess-work at the time appraisal takes place. Uncertainties also abound in relation to the choice of costs (including capital financing costs) and the choice of alternatives. Economic and political uncertainties give rise to many types of risk, ranging from general business risk to country risk and foreign exchange risk. These are often compounded by technological progress, which has serious impact on investments into new capital and machinery. For these reasons, considerations of risk and uncertainty are paramount in investment appraisal discussions and are commonly highlighted as critical factors for consideration at an early stage of analysis.

This sub-section reviews the investment and capital budgeting process, introduces risk; specifically systematic risk (beta), and outlines both traditional and time value of money investment appraisal techniques. Finally, it considers whether the company's weighted-average cost of capital should always be the appropriate discount rate for investment appraisal decisions.

Source: Investment and Project Appraisal - Hassan Hakimian & Erhun Kula, Centre for International Education in Economics, University of London

Week 3 Investment Appraisal - Basic Techniques.pdf