Investment Appraisal - Methods And Considerations

 

Project Evaluation Under Risk and Uncertainty

 

A firm conducts its business in a rapidly changing and highly competitive environment. The changing environment poses both opportunities and threats for the company.  For example, change in Government policy may cause change in prices of inputs and outputs, demand and supply of products/services. Similarly, technology change may cause the production cost change. Also the cash inflows and outflows cannot be ascertained with accuracy. Therefore, evaluation of investment projects under uncertainty and risk become important.

 

Characteristically, a capital investment decision involves largely irreversible commitment of resources that is generally subject to a significant degree of risk. Such decisions have far reaching effects on a company's profitability and flexibility over the long-term, thus requiring that they be part of a carefully developed strategy that is based on reliable forecasting procedures.

 

Typical examples of capital budgeting topics are:

• expansion projects;
• replacement projects;
• selection among alternatives; and
• buy or lease decisions.

 

Good capital budgeting decisions, based on sound investment appraisal procedures, should improve the timing of capital acquisitions as well as the quality of capital acquisitions.

 

Investment in expansion/ modernization is one of the main sources of economic growth, since it is required not only to increase the total capital stock of equipment and buildings, but also to employ labor in increasingly productive jobs as old plant is replaced by new.

 

Various criticisms have been put forward in relation to the methods of appraisal that many companies employ. Among the most important are:

1.                  Although most companies only make investment decisions after careful consideration of the likely costs and benefits as they see them, these decisions are often reached in ways that are unlikely to produce the pattern or level of investment that is most favorable to the economy's growth-or even most profitable to the company.

2.                  Many companies apply criteria for assessing investment projects that have little relevance to the measurement of the expected rate of return on capital invested (ROI).

3.                  Even though a calculation of the ROI of each project may be made, the methods used vary widely and are sometimes so arbitrary as to give almost meaningless results. (For instance, a failure to assess returns after tax is a frequent weakness of many widely used methods, since alternative opportunities can only be effectively compared and appraised on an after-tax basis.)

 

This faulty use of means of investment appraisal may result in over-cautious investment decisions in which too high a rate of return is demanded before the equipment is installed. This causes delay in economic growth. Alternatively, faulty methods may mean that investment decisions are made that result in the selection of projects that yield an unduly low ROI. This causes a waste of scarce capital resources, which is also unfavorable to economic growth.

 

No matter which technique is adopted for investment appraisal, the following steps need to be followed:

1.                  Determine the profitability of each proposal;

2.                  Rank the proposals in accordance with their profitability;

3.                  Determine the cut-off rate;

4.                  Determine which projects are acceptable and which unacceptable in relation to the cut off rate; and

5.                  Select the most profitable proposals in accordance with the constraints of the company's capital budget.