The Techniques For Investment Appraisal

Techniques For Investment Appraisal

INTRODUCTION

Different techniques are available by which to evaluate the original needs of development. In some cases these rely upon investment appraisal techniques that assess the expected profitability of undertaking such jobs. Other techniques may also be used that attempt to form a relationship between the benefits that may be achieved by the compared with the costs involved with the project.

The Techniques For Investment Appraisal

1. Payback period
2. Average rate of return
3. Discounting method

• The Pay-Back Period Method

This is literally the amount of time required for each inflows from a capital investment to equal the cash outflows. Put differently, it consists of assessing investment by the amount of time that it will take for profits from the project to pay back the total cost. A cut-off point can be chosen, beyond which the project will be rejected if the investment has not been paid off. The usual way that investor / firms deal with deciding between two or more projects is to accept the project that has the shortest payback period.

Payback period = Initial payment / outlay + Annual cash inflow

So, if N4 million is investment with the aim of earning N500,000 per year (net cash earning), the payback period is calculated thus:

P = N4,000,000 ÷ N500,000 = 8 years

This all look fairly easy! But what if the period has more uneven cash inflows? Then we need to work out the payback period on the cumulative cash flow over the duration of the project as a whole.

Merit Of Payback Period

1. It is popular because of it is simple and easy to calculate.
2. In a business environment of rapid technological change, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential.
3. If the future market of the product is particularly difficult to assess, perhaps because of other firms expanding into the same line of production, the projects giving early payback will be most valuable, and this method of assessment will have some validity.
4. It helps to identify how quickly the cash flow might become positive on the project – useful where firms have cash flow problems.

Demerit

1. The method takes no account of expected profits earned after the payback period.
2. It can give an overly simplistic view of the situation.
3. IT does not look at the long-term profitability of the project since it takes no account of cash flows beyond the pay-back period. It is therefore difficult to make comparisons between project with different life expectancies using this criterion.
4. Finally, it takes not account of what is happening with interest rate.

• Average Rate of Return

The average rate of return is the ratio of profit (net of depreciation) to capital. The average rate of return used to be the main method of investment appraisal as it purports to measure exactly what is required, namely the annual profit as a percentage of the capital invested. Taking the total profits earned on the investment over the whole of its life and dividing by the expected life of the project in years perform calculation of the average profit. Total profit is the total cash inflows less the total cash outflows, which automatically considers depreciation. The average investment is normally regarded as half the original investment because the end of its useful life will wholly depreciate it. This means that the most typical figure to represent a gradually reducing investment over the years is the average of its initial cost and its fully depreciated value of zero.

DEMERIT

• The rate of return does not readily rank projects in their order of merit.
• The rate of return method does not consider timing in its calculation.
• It concentrates solely on averaging the total profits earned over the whole life of the project, irrespective of the years in which they are earned.

• Discounting Method

The techniques of discounted cash flow (D.C.F) has been developed primarily by economists and accountants as a tool in the decision making process. It is used to assess the profitability of investment projects given certain criteria. It may be used to calculate whether or not a particular project meets such criteria as laid down by management, or to compare projects one with another to ascertain which is most profitable. Discounting methods are based on the fact that N1 today is worth more than an equal sum of money at some time in the future even ignoring inflation. This known as time value of money. This because it allows for the possibility of investment consumption taking place at the intervening period. This principle is valid independently of inflation, which also result in immediate money being work more than future money. In a period of high price inflation, discounting techniques are of even greater importance than previously for accurate investment appraisal.

To make a D.C.F calculation, all future costs and receipts have to be estimated and tabulated. In the case of land development, the cost will normally be the original capital outlay, and the receipts will be the income generated thereby.

There are two major methods of making D.C.F calculations, namely:

1. The Net present value (N.P.V) method, and
2. The Internal Rate of Return (I.R.R) method.
   1. NET Present VALUE (NPV):

• The future stream of benefits and costs converted into equivalent values today. This is done by assigning monetary value to benefits and cost. Discounting future benefits and cost using an appropriate discount rate, and subtracting the sum total of discounted costs from the sum total of discounted benefits.
• NPV establishes what the value of future earnings is in today’s money. To do the calculation you apply a discount % rate to the future earning. Further out the earnings are (in years) the more reduced the net present value. The discount rate should reflect the opportunity cost of the resources devoted to the investment. What the resources could have earned if they had been invested elsewhere.
• Total discounted revenue (referred to as “Present Value of Revenues”) less total discounted costs (referred to as “Present Value of costs”). This method is one of the better financial measures of an investment.
• NPV tells us how much the property is worth now to the investor. IRR tells us the rate of return if the property is bought at a certain price.
• The sum of the present value of all costs and monetary valued benefits of a facility over its economic life.

1. Internal rate of return (IRR) or Internal yield

The concept of an internal rate of return as a measure of performance, or return on investment, is not new, nor is it peculiar to real estate investments. It is safe to say, however, that the internal rate of return (IRR) did not enjoy widespread use until modern computer technology simplified the process of cash flow analysis and remove the drudgery of repetitive calculations. Use of the IRR and related yardsticks is no longer impractical and has to become commonplace. The increased practical applications have been so rapid that the rationale of the IRR is sometimes left unexplained.

The Internal Rate Of Return As A Discount Rate

It has been state that the terms interest rate and discount rate are often used interchangeably. If the IRR can be explained as an interest rate, it follows that the IRR should also be explainable as a discount rate. A future payment can be discounted to present value by calculating the amount that should be invested now to grow with compound interest at a satisfactory rate to equal the future. The standing discounting formular for converting future value to present value is:

Present Value = Future Value (I)

                                (n=r)^t

Where r is the rate of return on capital per period and n is the number of years (periods) that payment will be deferred. If a series of future payments is discounted, using the standard formula and the total present value of the series is the sum of all the present values.

Findings The Internal Return

Finding the IRR is by trial and error. Occasionally the IRR can be calculated mentally, or directly, without using trial rates. The usual procedure, however is to calculate the net present value of the cash flows, using various trial rates, until one is found that will satisfy the IRR equation. The objective is to find the rate that will make the net present value equal to, or nearly equal to zero.

The process that requires some education guess work to establish a starting point, but from that point on it is not difficult to zero in on the IRR. If the trial rate produces a net present value greater than zero, we know that in most cases, the trial rate is less than the true IRR. If the trial rate produces a net present value less than zero, we know that, in most cases, the trial rate is greater than the true IRR. With this knowledge, we can sense the direction for the search to locate the IRR by bracketing. When the bracketing defines a narrow range, a close approximation of the IRR can be obtained either by linear interpretation or by similar triangles.

CONCLUSION

Investment appraisal refers to a series of analytical technique designed to answer the question – should we go ahead with a proposed investment? What are these techniques: There are four techniques and all involve a comparison of the cost of the investment project with the expected return in the future.

The four techniques

Payback: The time taken to recover the cost of the investment

Accounting Rate of Return: Profits earned on investment expressed as a stage of the cost of investment.

NET Present Value: The present value of net cash flows received in the future less the initial cost of the investment.

Internal Rate of Return: The discount rate that causes the net present value of an investment to be zero.

The non – discounting methods

• The first two methods are non – discounting methods
• The financial return from an investment comes in a stream over a number of years.
• The non-discounting methods make not distinction between the return which comes in ten years time from the return that will come during the current year.
• In other words these methods ignore the time value of money.

The discounting methods

• The significant feature of these methods is that they take into account the time value of money.
• What this means is that we recognized money received in the future does not have the same value as money received today.

 

 

REFERENCES

1. Olayonwa G. (2000) Property Management; Principles and Practice Iwo Debo Publishing Company.
2. Olayonwa G.O. (2012) Property Valuation, Iwo Debo publishing company, Iwo.