tutor2u | Evaluating Investment Appraisal

Study Notes

Evaluating Investment Appraisal

Level:
AS, A Level
Board:
AQA, Edexcel, OCR, IB

Last updated 22 Mar 2021

Given the range of investment appraisal methods and the need for a business to allocate resources to capital expenditure in an appropriate way, what key factors do management need to consider when making their investments?

The key issues to consider are:

Risks and uncertainties

All business investments involve risk – the probability that the hoped-for outcome will not happen. An investment needs to earn a return that compensates for the risk.

The risk of a capital investment will vary according to factors such as:

Length of the project

The longer the project, the greater the risk that estimated revenues, costs and cash flows prove unrealistic

Source of the data

Are estimated project profits and cash flows based on detailed research, gut feel, or a little of both?

The size of the investment

An investment that uses a substantial proportion of the available business funds is, by definition, more risky than a smaller project. Risk is also about the consequences to the business if something goes wrong!

The economic and market environment

A major issue for most large investments

Most projects will make assumptions about demand, costs, pricing etc which can become wildly inaccurate through changing market and economic conditions

The experience of the management team

A project in a market in which the management team has strong experience is a lower-risk proposition than one in which the business is taking a step into the unknown!

Qualitative influences on investment appraisal

An investment decision is not just about the numbers. A spread sheet calculation for NPV or ARR might suggest a particular decision, but management also need to take account of qualitative issues such as:

  • The impact on employees
  • Product quality and customer service
  • Consistency of the investment decision with corporate objectives
  • The business' brand and image, including reputation
  • Implications for production and operations, including any disruption or change to the existing set-up
  • A business' responsibilities to society and other external stakeholders

Quantitative influences on investment appraisal

The investment appraisal comes up with a result, but how is a decision made?

Many firms set what are known as "investment criteria" against which they judge investment projects.

A problem with the three main investment appraisal methods is that they can generate seemingly contradictory results. For example, an investment might have a long payback period because the returns only occur several years into the project (possibly too long to be acceptable). However, if those returns are significant to the original investment, it is likely that the NPV or ARR would suggest going ahead.

The use of investment criteria is intended to help guide management through these decisions and address the potential conflicts.

So possible criteria might suggest only accepting investment proposals which meet at least two of the following:

  • A payback within four years
  • ARR of at least 20%, with no profits taken into account beyond Year 5
  • NPV of at least 25% of the initial investment

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