Traditional investment appraisal techniques

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Traditional investment appraisal techniques

Discounted pay back period Real option analysis Net Present Value NPV — this capital investment appraisal technique measures the cash in-flow, whether excess or shortfall, after the routine finance commitments are met with.

All capital investment appraisals have a single objective — drive towards a positive NPV. The NPV is a mathematical calculation involving net cash flow at a particular present time 't' at discount rate at the same time, i.

Thus there is an inverse proportional relation between discount rate and NPV. A high discount rate would reduce the net present value of capital. A high interest rate increases discount rates over a period of time and most capital investment appraisals are wary of such an increase.

Traditional investment appraisal techniques

Accounting Rate of Return ARR — this capital investment appraisal technique compares the profit that can be earned by the concerned project to the amount of initial investment capital that would be required for the project. Projects that can earn a higher rate of return is naturally preferred over ones with low rate of return.

ARR is a non discounted capital investment appraisal technique in that it does not take into consideration the time value of money involved. Among all capital investment appraisal techniques, IRR is generally considered to measure the efficiency of the capital investment. Thus, if cost of capital investment in company works out to be greater than the IRR value, the project is highly likely to be rejected.

On the other hand, a low cost of capital has more chances of being accepted. IRR considers the time value of money over the project life time and derives the world discount rate. Modified Internal Rate of Return MIRR — the IRR does not give the actual annual profitability of a capital investment since it does not take into consideration the intermediate cash flows which is never reinvested equalling project IRR.

Hence the IRR capital investment appraisal technique is not effective enough since the rate of return in actual is certainly going to be lower. This flaw is over come by a more efficient capital investment appraisal technique — MIRR.

MIRR evaluates capital investment projects assuming that reinvestment rate equals the company's cost of capital.

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Adjusted Present Value APV — APV capital investment appraisal technique overcomes the shortcomings of NPV technique and evaluates a project on the basis of risks associated to prospective company undertaking the investment. Profitability Index PI — evaluates a project based on calculation of value per unit of investment.

Also known as value investment ratio and profit investment ration, this capital investment appraisal technique is a ratio of amount of money invested to profit or pay off of the project. Equivalent Annuity — capital investment appraisals done using equivalent annuity usually compares projects with different life spans.

In cases where two projects have different time spans, NPV would not justify a fair comparison. This capital investment appraisal technique divides the NPV value with annuity factor resulting in expressing NPV in relation to annualized cash flow.

Payback Period — appraising capital investment on the basis of time that would be taken to get back your initial investment is called as payback period. Payback period is one of the easiest methods of capital investment appraisal techniques.

Projects with a shorter pay back period are usually preferred for investment when compared to ones with longer pay back periods.

Introduction

Discounted Payback Period — capital investment appraisals using discounted payback period is similar to payback period but here, the time value of money or discounted value of cash flow is considered for calculation of payback period.

Real Option Analysis — capital investment appraisals using real option analysis considers and values the various options that managers would have while managing their projects in terms of increasing cash in flow ans decreasing cash out flow.

These values are added to NPV in the course of capital investment appraisals. All the above mentioned capital investment appraisal techniques are used for ranking projects.

Usually, organizations have many projects that are appraised simultaneously for financial viability. Once the preliminary appraisal of a project is completed, it is compared and ranked against other peer projects.

The projects in consideration are ranked from having high Profitability index to lowest Profitability index. The higher ranking projects are usually implemented after careful and detailed due diligence.However, traditional appraisal techniques are a powerful ways of appraising investment projects.

Traditional investment appraisal techniques

There is a need though for all decision makers, when evaluating projects, to clearly understand of the pitfalls arising from the use of traditional appraisal techniques.

The problems of traditional appraisals are not the techniques themselves. Atrill & McLaney (, p) describe the four main methods of investment appraisal to be: 1) Accounting Rate of Return (ARR) 2) Payback Period (PP) 3) Net Present Value (NPV) 4) Internal Rate of Return (IRR) It is noted that companies do have variations on .

“Traditional Investment Appraisal Techniques Cannot Cope With the Fast Changing Environment in Manufacturing Industry Today” Introduction “If you can't measure it, you can't manage it”.

Traditional Investment Appraisal Techniques Introduction With the growing competition between companies in the same segment, the diversity of decisions has been listed by financial professionals of the companies, which is not enough to master the classical techniques of financial management.

Two basic appraisal techniques covered here are Return on Capital Employed (ROCE) and Payback. There are other more sophisticated methods of investment appraisal such as Net Present Value (NPV) and Internal Rate of Return (IRR). Performance Appraisal Methods: Traditional and Modern Methods!

Each method of performance appraisal has its strengths and weaknesses may be suitable for one organisation and non-suitable for another one.

As such, there is no single appraisal method accepted and used by .

Traditional Investment Appraisal Techniques , Sample of Business plans