Why Is the Investment Appraisal Process so Important?

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A) Why is the investment appraisal process so important?

Capital Investment Appraisal is of fundamental importance because:

1. Large Amount of Company Resources: Involvement of large amount of company resources and efforts which will necessitate careful evaluation to be undertaken before a decision is reached.

2. Maximization of Shareholder wealth: Investment decision is linked with strategic and tactical business decisions and therefore need to achieve desired long-term objectives. The most usual objective being the maximization of shareholder wealth.

3. Difficult to Reserve: It can be very expensive and perplex to reserve an investment decision so caution need to be exercised in reaching the initial investment decision.

4. High Risk Involvement: Projected future benefits and costs are hard to forecast. As a result, the risk and uncertainty of undertaking medium to long-term investment can be high.

B) What is the payback period of each project? If AP Ltd imposes a three year maximum payback period which of these projects should be accepted?

Payback period for project A:-

| | | | |YR |NCF |CF | |1 |20 |20 | |2 |30 |50 | |3 |40 |90 | |4 |50 |140 | |5 |70 |210 |

Payback period of project A = 3 + 20/50
= 3 + 0.4
= 3.4 yrs, i.e., 3yrs 4.8 months.

Payback period for project B:-

| | | | |YR |NCF |CF | |1 |40 |40 | |2 |40 |80 | |3 |40 |120 | |4 |40 |160 | |5 |40 |200 |

Payback period of project B = 2 + 30/40
= 2 + 0.75
= 2.75 yrs, i.e., 2yrs 9 months.

When examining two new investment projects of AP Ltd, as in the case of projects A and B, the usual decision is to accept the one with the shortest payback, assuming the payback period satisfies some preconceived target. However, when only one investment opportunity is being examined, the payback of that opportunity will be compared with a target payback. This concept of a target payback could be employed in the case of projects A and B above. The payback target is 3 years, so project B should be accepted because it pays back after 2 years 9 months where as project A payback only after 3 years and 4.8 months which is more than the target. The longer the time...
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