The primary purpose of investment appraisals is to help businesses make informed investment decisions by providing a systematic and objective way of evaluating potential investment opportunities. Investment appraisals also help businesses allocate their financial resources more effectively by identifying the investment projects that are most likely to generate the highest returns.
Investment appraisals typically involve several steps, including identifying potential investment opportunities, estimating the cash flows associated with each opportunity, evaluating the risks and uncertainties associated with each opportunity, selecting the most promising investment opportunities, and monitoring and reviewing the performance of the selected investments over time.
The primary goals of investment appraisals include:
Assessing the potential profitability of an investment project: Investment appraisals help businesses determine the potential profitability of an investment project by estimating its future cash flows and comparing them with the costs of the project.
Evaluating risk and uncertainty: Investment appraisals also help businesses evaluate the risks and uncertainties associated with an investment project, such as market conditions, competitive pressures, and technological changes.
Prioritizing investment opportunities: By comparing the expected returns and risks of different investment projects, businesses can prioritize and select the most promising investment opportunities.
Allocating financial resources: Investment appraisals also help businesses allocate their financial resources more effectively by identifying the investment projects that are most likely to generate the highest returns.
Investment appraisals provide businesses with a systematic and objective way to evaluate potential investment projects, make informed investment decisions, and maximize their return on investment.
There are several methods of investment appraisals that businesses can use to evaluate potential investment projects. Here are some commonly used methods:
Net Present Value (NPV): NPV is a popular method of investment appraisal that calculates the present value of future cash flows generated by an investment project, minus the initial investment cost. If the NPV is positive, the investment is considered to be profitable, and if it's negative, the investment is considered unprofitable.
Internal Rate of Return (IRR): IRR is another widely used method of investment appraisal that calculates the rate of return that a project is expected to generate over its lifetime. If the IRR is greater than the required rate of return or the cost of capital, the project is considered to be acceptable.
Payback Period: Payback period is the time it takes for the initial investment to be recovered from the project's cash flows. This method measures the time taken for the project to break even. A shorter payback period is generally preferred.
Accounting Rate of Return (ARR): ARR calculates the average annual profit generated by the investment relative to the initial investment. The ARR is compared to the required rate of return to determine the acceptability of the investment.
Modified Internal Rate of Return (MIRR): MIRR is a variation of the IRR method that considers the reinvestment of cash flows generated by the project. MIRR is used when cash flows cannot be reinvested at the project's internal rate of return.
By using one or more of these methods, businesses can evaluate potential investment projects objectively and determine the best course of action.