Investment Appraisal Techniques: Meaning, Characteristics, and Importance

Investment appraisal refers to a decision making process where investments are made today and the benefits occur in the future. Investment appraisal can also be defined as the process of assessing various investments or projects to determine their attractiveness. It plays an important role in identifying long term trends in an industry and assessing the potential of a company in terms of profitability and growth.

The methods of investment appraisal are payback period, accounting rate of return (ARR), and the discounted cash flow methods of net present value (NPV) and internal rate of return (IRR). For each of these methods students must ensure that they can define it, make the necessary calculations and discuss both the advantages and disadvantages.

There are three steps involved in evaluating investments:

  • Estimating cash flows
  • Estimating the required rate of return (the opportunity cost of capital)
  • Applying a decision rule in making a choice

An investment decision rule refers to as capital budgeting technique, or an investment criteria, or an investment appraisal technique. It is the technique or criteria that a company uses to make an investment decision. An appraisal technique is a way of measuring the economic value of an investment project.

Characteristics of an Investment Evaluation Criterion

An appropriate investment evaluation criterion or an appraisal technique has several distinguishing features or characteristics. The primary feature of a sound investment criteria is that it should maximize stakeholder’s wealth. Other characteristics of a sound investment evaluation technique are:

  • It should consider all cash flows to determine the true profitability of the project.
  • It should provide for an objective and unambiguous way of separating good projects from bad projects.
  • It should help ranking of projects according to their true profitability.
  • It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones.
  • It should help to choose among mutually exclusive projects that project which maximizes the shareholders’ wealth.
  • It should be a criterion which is applicable to any conceivable investment project independent of others.

Importance of Investment Appraisal Techniques

Investment appraisal is important for a company because it enables them to analyze existing and potential investment projects. The use of investment appraisal techniques to evaluate various investment projects is important for the following reasons:

  • Large amounts of capital: investments require a large amount of money to implement. For this reason, a company needs to use investment appraisal to assess the available investment options and ensure that the firm invests its resources in viable projects. The involvement of a large amount of resources necessitates careful evaluation for effective decision making.
  • Maximization of Stakeholders’ Wealth: Companies that use equity to raise capital will always focus on the interests of their shareholders. Investment decisions are made with the interests of shareholders in mind because every shareholder wants to see their investments grow. Therefore, one of the major long term objectives of a company is to maximize shareholders’ wealth. Managers conduct investment appraisals to ensure that they invest shareholder’s money on viable projects that will increase the returns on their investments.
  • Profitability and Growth: Another important objective of a firm is profitability and growth. This is also related to shareholder’s value because higher profits means higher returns for shareholders. However, earning returns is not an easy thing for companies to achieve because every investment involves risks. Managers use various investment appraisal techniques to investment decisions and choose projects that have the potential of generating higher profits.
  • Cost Minimization and Risk Reduction: Investment appraisal techniques are also important because they can be used to minimize costs and reduce risks. Investments always involve a large sum of money, while resources are scarce. Therefore, investment appraisal allows a business to evaluate various projects and choose those that incur less risks and costs. Lower costs means increased profits, and lower risks means less chances of making losses.
  • Project Funding: Companies also use investment appraisal techniques to make decisions regarding the sources of funds. Funding a project requires different sources of funds, which are not always appropriate for every project. Funding will be varied depending on the investment needs of the organization as well as the interests of shareholders. Investment appraisal allows the company to determine the funding needs of each project and ensure that there is enough funding before commencing the project.

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