Investment appraisal is a scientific process of evaluating the financial and non-financial factors to determine the economic viability of an investment opportunity. Another name for investment appraisal is capital budgeting.
Companies create value for the owners of a company by investing in projects that have positive NPV (net present value). The reason behind this is that by making superior investments with positive NPV, investors stand the chance of making more in the future.
INVESTMENT DECISION RULES
I will be stating the investment decision rules under different methods of project evaluation.
NPV: NPV is technically the superior investment appraisal tool, its investment decision is based on selecting investment or project with positive NPV. It is assumed that every project that has a positive NPV can be accommodated by the available fund. Under a period of cash shortage, a method known as (PI) profitability index will be used.
IRR: IRR is an acronym for internal rate of return. Its acceptance or rejection criterion is based on a set rate of return. The IRR method of investment appraisal is to accept projects whose IRR (the rate at which the NPV is zero) exceeds a target rate of return. The IRR is calculated through interpolation method. You accept project if it has a rate that is greater than the minimum required rate.
PI: profitability index is the ratio of the present value of a project’s future cash flows divided by the present value of the total capital investment. Note that there is difference between cash flow and profit.
Payback method: here, the investment rule is to accept projects with shortest period for the projects cash flow to be recouped.
If things are done right, investment appraisal should add value to business venture.