INTRODUCTION TO INVESTMENT APPRAISAL
Capital Expenditure/Budgeting Decision
Capital Expenditure is spending on non-current assets, such as buildings and equipment, or investing in a
new business. As a result of capital expenditure, a new non-current asset appears on the statement of
financial position (balance sheet), possibly as an ‘investment in subsidiary’.
Capital expenditure by a company should provide a long-term financial return, and spending should
therefore be consistent with the company’s long-term corporate and financial objectives. Capital
expenditure should therefore be made with the intention of implementing chosen business strategies
that have been agreed by the board of directors. Many companies have a special budget, and capital
expenditure is undertaken within the agreed budget framework and capital spending limits. For
example, a company might have a five-year capital budget, setting out in broad terms its intended
capital expenditure for the next five years. This budget should be reviewed and updated regularly,
typically each year.
Investment appraisal
Investment appraisal is the evaluation of proposed investment projects involving capital expenditure.
The purpose of investment appraisal is to make a decision about whether the capital expenditure is
worthwhile and whether the investment project should be undertaken.
Before capital expenditure projects are undertaken, they should be assessed and evaluated. As a general
rule, projects should not be undertaken unless:
• They are expected to provide a suitable financial return, and
• The investment risk is acceptable.
Features of investment projects
Many investment projects have the following characteristics:
• They are expected to provide a suitable financial return, and
• The investment risk is acceptable.
Features of investment projects
Many investment projects have the following characteristics:
1. The project involves the purchase of an asset with an expected life of several years.
2. It involves the payment of a large sum of money at the beginning of the project.
3. The returns on the investment usually spread or accrue over the useful life of the
project/investment.
4. Capital decisions are irreversible in nature.
5. The asset might also have a disposal value (residual value) at the end of its useful life.
Methods of investment appraisal
, There are four methods of evaluating a proposed capital expenditure project. Any or all of the methods
can be used, but some methods are preferable to others, because they provide a more accurate and
meaningful assessment. The five methods of appraisal are classified in two groups as follows:
A. Non-Discounted Techniques:
1. Accounting rate of return (ARR) method
2. Payback method
B. Discounted cash flow (DCF) methods:
3. Net present value (NPV) method
4. Internal rate of return (IRR) method
Accounting Rate of Return (ARR)
If accounting rate of return (ARR) is used to decide whether or not to make a capital investment, we
calculate the expected annual accounting return over the life the project. The financial return will vary
from one year to the next during the project; therefore we have to calculate an average annual return.
If the ARR of the project exceeds a target accounting return, the project would be undertaken. If its ARR
is less than the minimum target, the project should be rejected and should not be undertaken.
Unfortunately, a standard definition of accounting rate of return does not exist. There are two main
definitions:
• Average annual profit as a percentage of the average investment in the project
• Average annual profit as a percentage of the initial investment.
You would normally be told which definition to apply. If in doubt, assume that the capital employed is
the average amount of capital employed over the project life.
NOTE:
Average Annual Profit = Total profit
2
Average investment = Initial Capital Outlay + scrap Value
2
Advantages and disadvantages of using the ARR method
Advantages of the ARR are that:
1. It is easy to understand.
2. It uses concepts that are familiar to business managers, such as profits and capital employed.
3. It is easy to calculate.
4. It considers all variables involved in the decision process.
Disadvantages of the ARR method are:
1. It is based on accounting profits, and not cash flows. However investments are about investing
cash to obtain cash returns. Investment decisions should therefore be based on cash flows and
not accounting profits.
2. Accounting profits are an unreliable measure. For example, the annual profit and the average
annual investment can be both changed by simply altering the rate of depreciation and the
estimated residual value.
Capital Expenditure/Budgeting Decision
Capital Expenditure is spending on non-current assets, such as buildings and equipment, or investing in a
new business. As a result of capital expenditure, a new non-current asset appears on the statement of
financial position (balance sheet), possibly as an ‘investment in subsidiary’.
Capital expenditure by a company should provide a long-term financial return, and spending should
therefore be consistent with the company’s long-term corporate and financial objectives. Capital
expenditure should therefore be made with the intention of implementing chosen business strategies
that have been agreed by the board of directors. Many companies have a special budget, and capital
expenditure is undertaken within the agreed budget framework and capital spending limits. For
example, a company might have a five-year capital budget, setting out in broad terms its intended
capital expenditure for the next five years. This budget should be reviewed and updated regularly,
typically each year.
Investment appraisal
Investment appraisal is the evaluation of proposed investment projects involving capital expenditure.
The purpose of investment appraisal is to make a decision about whether the capital expenditure is
worthwhile and whether the investment project should be undertaken.
Before capital expenditure projects are undertaken, they should be assessed and evaluated. As a general
rule, projects should not be undertaken unless:
• They are expected to provide a suitable financial return, and
• The investment risk is acceptable.
Features of investment projects
Many investment projects have the following characteristics:
• They are expected to provide a suitable financial return, and
• The investment risk is acceptable.
Features of investment projects
Many investment projects have the following characteristics:
1. The project involves the purchase of an asset with an expected life of several years.
2. It involves the payment of a large sum of money at the beginning of the project.
3. The returns on the investment usually spread or accrue over the useful life of the
project/investment.
4. Capital decisions are irreversible in nature.
5. The asset might also have a disposal value (residual value) at the end of its useful life.
Methods of investment appraisal
, There are four methods of evaluating a proposed capital expenditure project. Any or all of the methods
can be used, but some methods are preferable to others, because they provide a more accurate and
meaningful assessment. The five methods of appraisal are classified in two groups as follows:
A. Non-Discounted Techniques:
1. Accounting rate of return (ARR) method
2. Payback method
B. Discounted cash flow (DCF) methods:
3. Net present value (NPV) method
4. Internal rate of return (IRR) method
Accounting Rate of Return (ARR)
If accounting rate of return (ARR) is used to decide whether or not to make a capital investment, we
calculate the expected annual accounting return over the life the project. The financial return will vary
from one year to the next during the project; therefore we have to calculate an average annual return.
If the ARR of the project exceeds a target accounting return, the project would be undertaken. If its ARR
is less than the minimum target, the project should be rejected and should not be undertaken.
Unfortunately, a standard definition of accounting rate of return does not exist. There are two main
definitions:
• Average annual profit as a percentage of the average investment in the project
• Average annual profit as a percentage of the initial investment.
You would normally be told which definition to apply. If in doubt, assume that the capital employed is
the average amount of capital employed over the project life.
NOTE:
Average Annual Profit = Total profit
2
Average investment = Initial Capital Outlay + scrap Value
2
Advantages and disadvantages of using the ARR method
Advantages of the ARR are that:
1. It is easy to understand.
2. It uses concepts that are familiar to business managers, such as profits and capital employed.
3. It is easy to calculate.
4. It considers all variables involved in the decision process.
Disadvantages of the ARR method are:
1. It is based on accounting profits, and not cash flows. However investments are about investing
cash to obtain cash returns. Investment decisions should therefore be based on cash flows and
not accounting profits.
2. Accounting profits are an unreliable measure. For example, the annual profit and the average
annual investment can be both changed by simply altering the rate of depreciation and the
estimated residual value.
