Investment appraisal

Investment appraisal

The process of investment appraisal is necessary in order to select the best projects for investment, whether they be replacement machines for the factory, office equipment or new cars for managers and sales representatives. Major factors to consider are:

• risk and return
• time scale
• time value of money
• evaluating alternative choices.

The first one, that of risk and return is important. A good general rule is to expect a high return if the investment is risky. That is why interest rates on mortgages are less than interest rates on loans for consumer durables. A bank will regard loans against property as low risk because a house is a better security than a refrigerator if something goes wrong. For commercial businesses some capital investment projects carry low risk, such as those which merely involve a replacement of a machine that is being used to make a product for which there is a regular demand. However, the risk is much greater for investment in a new factory for a range of new products. These different risk profiles have to be taken into account when comparing different projects for investment.

Time scale is important too. If a project is going to take 5 years for completion, then many things could change before completion including inflation, government action, market conditions, competitive pressures, etc. The investment decision must take account of all these risk factors as well and this is not an easy process, because of the need to forecast up to 5 years into the future.

Money has time value. This fact lies at the heart of the investment appraisal process. If you could choose to have £5 today or £5 in a year's time, which would you prefer and why?

Hopefully, you would take account of the risk of not getting your £5 in a year's time and would prefer to avoid risk and get it now. Also, you should have thought about the fact that if you had the £5 now, you could invest it for a year, so that it would be worth more than £5 in a year's time.

The time value of money exists because of these two aspects, risk and return. Most people who decide to save money instead of spending it look for a secure and lucrative place to keep it until they wish to spend it.

If your risk preference is low you would probably put your money into a building society account. If you were more adventurous you might buy shares. The risks attached to buying shares are greater than a building society account, but the return may be greater.

The essence of the capital investment decision is no different to this. A company must decide whether or not to keep its money in the bank or invest in the business. If it chooses to invest in the business, the company must expect a better return than merely leaving it in the bank. It is for this reason that certain techniques for evaluating projects have arisen. There are numerous approaches, but the most theoretically sound method is called Net Present Value (NPV) technique.