Topics: Net present value, Internal rate of return, Finance Pages: 8 (2303 words) Published: June 16, 2010





Critically evaluate the role and importance of investment appraisal models in achieving the financial management objectives of large companies.

Investment involves outflows of cash causing inflows of cash. It is in nature of things that cash flows (out and in) do not all occur at the same time, that is, there is some time lag, perhaps a considerable one, between them. The typical project opportunity involves a relatively large outflow of cash initially, giving rise to a subsequent stream of cash inflows.

Selecting which investment opportunities to pursue and which to avoid is a vital matter to businesses because individual projects frequently involve relatively large and irreversible commitments of finance and they involve this commitment for long, often very long period of time.

The investment decision is the most important one. Costly and far reaching mistakes and probably will be made unless businesses take great care in making their investment decisions. Bad decisions usually cause major financial loss, and any particular business can make only a limited umber of misjudgements before collapse occurs.

Investment Appraisal Models

It is important that financial resources should be deployed to best advantage and so good investment decisions are vital to successful financial management.

There are several techniques available whereby investment proposals can be evaluated. Since, however, all require projections of future costs and returns they cannot be guaranteed to lead to successful decisions. It can, perhaps be claimed that they increase the probability of success.

A highly sophisticated, apparently accurate, method of project appraisal with sound theoretical basis will not necessarily give sufficient extra success to warrant the cost involved in using it. There is a place, therefore for simple, rough and ready, techniques particularly for routine small investment decisions taken at a relatively low level of management.

All methods of investment appraisal use figures for the net returns expected from the project. This is not the same as accounting profit. It may best be seen as the contribution to be made by the project year by year, that is, revenue less direct costs (but not including depreciation).

The payback method of investment appraisal is fairly widely used in industry and is based on the following philosophy. The commitment of funds to any project involves two things. It involves forgoing the use of the funds in any other way so long as they are tied up, and involves the risk that the money committed will be permanently lost. Both factors are related to time. The longer the funds are tied up the longer before they can be reused and, in general, the greater the risk non-recovery. The payback method, then, is based on management concerned to be reimbursed the initial outlay as soon as possible. Overall profitability is left to care of itself.

An arbitrary required payback period is determined by management. Let us say that, for example, this period is three years. Management, that is, is saying that it is willing to invest in any project which repays its initial cost within three years but not if it takes longer than this.

The payback method has the advantage that:
• It is simple to understand and to apply
• It promotes a policy of caution in investment
• Empirically it can be shown to produce satisfactory results

Its disadvantages are:
• It disregards total contribution and so could favour projects with a poor overall profitability just because they had a relatively large initial cash inflow • It could prevent investment in the very best projects of all which characteristically take years of development before they reach maximum profitability.

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