Why is investment appraisal process so important

why is investment assessment process so master(prenominal)Investment decisivenesss are of critical enormousness to all companies, since they determine both their potential to succeed and their ultimate address structure. Investments usually implicate high sign inter transplant out head for the hillss and thus nexus up substantial funds. Sound investment decisions are crucial, therefore. Yet, according to a highly complex and fastly changing business environment they remain a challenging management task.A non bad(p) investment appraisal is utilise to make sure time comfort for money with regard to developing an landed estate st gradegy and capital excogitate. It is non an distinction of loss or profits for the company as a whole but rather a comparision of salute with regard to those areas of the estate where there is an opportunity or a demand for change. (Baum T., Mudambi R., 1999).Capital investment decisions are the important criteria to be apply by an organiza tion in order to apply its corpo deem strategy. Because of this, it has to intromit strategical decisions, marketing decisions and human recources implications that are an overall business review. These decisions implicate expansion, terms reduction, market development, acquisitions and disposals, lease or buy. It is possible to evaluate the harshness of the opportunities for an investment appraisal by comparing the expect benefits with the anticipated represents as its adjudicate. ( Kind J, 1999 p.122)(b) What is the retribution period of each project? If AP Ltd imposes a 3 course maximum payback period which of these projects should be au thustic?Payback for spue AYears boodle hard property in flowCumulative exoneratecash flow0000000(110)(110)120202305034090450140570210Total 3+=3.4 daysPayback for Project BYearsNet cash flow0000(110)140240340440540Total = 2.7 yearsc) What are the criticisms of the payback period?Payback is a type of step that indicate the needful period of time required for the recovery of the initial investment.There is a necessity of clarification that the payback fundament not be use as an only decision criterion because it does not include any profits or cash flows occurring after the payback period. Second, payback gives equal weight to all cashflows before the cutoff period, condescension the fact that the much distant cashflows arc less valuable.( Mott, 2005, p 217.)It is a compulsory for a company to determine a proper shutting time for the investment in order to use payback method. similarly many short-lived projects go out be chosen by the company rather than long term ones in case of using the same(p) date without taking into account the project life.Also it can be considered as an effective auxiliary investment appraisal tool since virtually possible risks that may arise from an investment project can be indicated by payback. As paralel to this, it might be thought as an important factor for the considerat ion of the economic life of a project as a consecuence of a sensitivity analysis. (Gtze U, 2008, p.46)Although it has weaknesses, payback will be utilize as one of the main decision making tecniques because the simplicity is the restorative of this investment appraisal method. And as well it has short term perspective that leads decision making. In case of consideration of more(prenominal) complex projects,we should use mod analysis like Net bear witness care for method and recollect carrefully what might be at risk. ( Dyson, 2007, p.422)(d) Determine the NPV for each of these projects? Should they be genuine explain why?NPV for Project AYearsNet cash flowDiscount factor afford tax00012%0001200.89317.862300.79723.913400.71228.984500.63631.85700.56739.69_______Total bring in range141.74Less initial approach110Net bribe value31.74NPV for Project BYearsNet cash flowDiscount factorPresent value00012%0001400.89335.722400.79731.883400.71228.484400.63625.445400.56722.68_____ __Total stage value144.2Less Initial cost110Net present value34.2Both projects should be accepted, since both Net Present determine are positive according to ACCEPT-REJECT decision making techniques.If we use rank decision making techniquesProjectemailprotected 12% Discount Rate000B34.20A31.740As it can be seen from the rankings Project B is more preferable with a higher NPV.(e) Describe the logic behind the NPV approach. inter gain PRESENT VALUE METHODOne of the most widely know and used technique of financial analysis is Net Present Value method. It is a comparision of the value of money now and that of the future. A pound now is precious more than a pound in the future, because the buying condition of the future money is eroded by the effect of inflation.Importance of judgment of conviction Value of Money in Financial ManagementThe time value of money is the fundamental for financial management because it is the aid of determining present value in todays paund of the future net cash flow of a project. Therefore you can obtain a comparision of that effect of money with necessary amount of money to carry out the project.Any of financial decisions mustiness(prenominal)(prenominal) not be taken in case of the equality of inflows and outflows because of incertain future conditions. In order to purchase assets the inflow must be above the outflow. If the purpose is to raise the funds then outflow must be kept more than the inflow. And it is required that the inflow and outflow can be matched. In order to make effective financial decision, the flows expected in the future must be adjusted on the purpose of being compared with the current ones.( Ramagopal, 2008, p.221)The procedure of Net Present Value tallyNet present value method can be used to examine the profitability of all investment projects.If the net present value 0 The project is feasibleIf the net present value 0 The project is not feasibleIf the NPV is greater than the cost, the project wil l be gainful for the company. In the case of having more than one project, you should calculate Net present value of all, and the superior one that has the most difference between Net present value and cost must be chosen. Project that its net present value is bigger than zero, are considered to raise the value of the company. (Mott, 2005, p216)The advantages of this methodIt puts forward the value of 1 pound of today is more than that of 1 pound in the future. Because the return of todays investment will be received earlier than any of the future investments.The estimated cash flows and the opportunity cost of capital are examined by this method.In order to calculate the net present value for the whole project, the current values of the cash inflows and outflows could be added since present values are todays value. ( Kind J, 1999 p.127)The weakness of the model is that cash flows are accepted to be seen on the last day of the year depending on discounting once a year. On the other hand the precondition of the constant cost of capital during the whole life time of the project can be considered as the another weakness of the method. (Proctor, 2009, p.192)(f) What would happen to the NPV if(1) The cost of capital increased?If the cost of capital increases, discount rates decrease, which mode that present values of cashflows also decrease. As a result, NPV will also decrease, because there will be a decrease in the means of total present values of cash flow(2) The cost of capital decreased?Decreasing the cost of capital will increase discounting rates, which mean an increase in total present value of cashflows. Depending on this increase, NPV which includes the sum of total present values of cashflows will inevitanly increase.(g) Determine the IRR for each project. Should they be accepted?The net present value is most popularly alternated with interior(a) rate of return (IRR). IRR is defined as the discount rate or cost of capital at acme where the benefits are balanced with its costs, the net present value is equal to zero and so, can be considered as break even rate. It can be used as pass judgment of capital efficiency.Advantages of IRRLiquidity is considered in this method.It emphasize timing of net cash flow.The exact % return on investment is givenNPV FOR cypher AYearsNet cash flowDiscount factorsPresent value00017% 22%17% 22%000 0001200.855 0.8217.1 16.42300.731 0.67221.93 20.163400.624 0.5524.96 224500.534 0.45126.7 22.555700.456 0.3731.92 25.9_______ ______Total present value122.61 107.01Less Initial cost110 110Net present value12.61 (2.99)IRR= positive rate + -range of rates= = 17%+-5% =21.04%At 21.01% discount rate the NPV is equal to zero.NPV FOR PROJECT BYearsNet cash flowDiscount factorsPresent value00022% 27%22% 27%000 0001400.82 0.7872.863 2.5812400.672 0.6203400.55 0.4884400.451 0.3845400.37 0.302_______ ______Total present valueLess Initial cost110 110Net present value4.52 (6.76)IRR= positive rate + -range of rates = 22%+-5% =24%Since both projects IRR are bigger then cost of capital both of them can be accepted.(h) How does a change in the cost of capital affect the projects IRR?The IRR value of the project is not affected by a change in the cost of capital. The point that must be taken into account here is that IRR value must not be below cost of capital for the safety of the investment.(i) Why is the NPV method often regarded to be superior to the IRR method?The NPV calculation will usually always provide a more accurate indication of whether or not a project should be undertaken or not.However, since IRR is a percentage, and NPV is shown in money, it is more appealing for a manager to show person a particular rate of return, as opposed to money amounts.