Investment is a long-term commitment of precious funds and consequently it is extremely important to evaluate each investment carefully. Investment appraisal may be defined as the evaluation of an investment with a view to ascertain the returns or gains that are expected to accrue from it. While different techniques may be used in the process of investment appraisal, the major methods are: The Payback method, The Average Rate of Return (A.R.R) method and The Net Present Value (N.P.V) method. Read on to find out Investment Appraisal Guide with details about these methods and techniques.
Investment Appraisal Guide: Methods & Techniques
Following are the techniques and methods to identify the attractiveness of an investment.
1. Payback Method
The Payback method is the easiest method of investment appraisal and is usually preferred due to its straightforwardness. This technique is used for smaller investments and also by small businesss. For larger businesses and bigger investments this method may be used as a preliminary screening process before the application of other detailed techniques. The Payback period is the time taken for the investment (such as equipment, machinery etc.), to generate adequate fund flow that may be necessary to pay for itself. The drawback of this method is that it may lead to rejection of many slow yet stable investment options, even though they may prove to be highly lucrative in the longer run by providing high volume fund flow after a longer period of time.
2. Average Rate of Return (A.R.R) Method
The Average Rate of Return method has four basic steps:
- Arriving at an estimated net cash flow
- Deduct the capital outlay from the above estimation
- Divide the resultant figure by the expected life (in years) of the capital
- Express the resultant figure as a percentage of the capital outlay
This method involves calculation through arithmetic formulas and can be used in two ways. According to one method, a predetermined figure may be established before hand and rejection of an investment with expected A.R.R. less than the prescribed figure can be rejected. Projects and investment options may be ranked according to their A.R.R and then chosen. This method however, doesn’t hold regard for the time value of money.
3. Net Present Value (N.P.V) Method
The third method used is Net Present Value. The N.P.V. method, not only takes into account the size of the cash inflows over the life of the investment, but also makes adjustment for the timing of the money by applying weights. Greater importance is accorded to cash inflows in the initial years. The current value of each year’s cash inflow are aggregated and then compared to the figure representing the initial capital outlay. If the sum of present values after accounting for the cost of capital is positive, then it is worthwhile to go ahead with the investment.
These were some of the techniques to evaluate each investment. There are many other qualitative factors that can also utilized to appraise the utility of the investment.
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