Capital Investment Appraisal

1005 Words Jul 17th, 2008 5 Pages
Evaluate the different methods of capital investment appraisal available to organisations and clearly show when each method would be used (if at all) illustrating your answer with relevant examples.
Capital investment appraisal can be described as the decision-making process used by organisations to evaluate different investments and to decide which fixed assets to purchase. In the following, four different methods of investment appraisal shall be discussed: accounting rate of return (ARR), payback period, net present value (NPV) and internal rate of return (IRR).
The ARR expresses the return on an investment as an annual percentage of the cost of that investment. To decide whether to accept or reject a project, organisations can set a
…show more content…
It is determined by calculating the discount rate that gives an NPV of zero, also taking into account the changing value of money over time.
If the IRR of a project is higher than the cost of capital, the project should be accepted as it adds value for the company. Problems regarding the IRR arise when mutually exclusive investments are appraised. The IRR shows how much profit an investment yields in relative terms while the NPV uses absolute values. Although a project has a higher IRR than another one, it might still be less profitable in absolute terms. Another problem can arise when there are complex patterns of cash flows, which leads to multiple IRR for a single project. This complicates the decision. The IRR also assumes that all inflows earned will be reinvested at an equal rate of return, which might be unreasonable. The NPV, on the other hand, only assumes that they can be reinvested at the discount rate, which is a more reasonable assumption.
The IRR can be used for appraising a project, but it should not be used to compare mutually exclusive projects.
Taking everything into consideration, the NPV is the most satisfactory method of capital investment appraisal as it gives the most accurate results. Other methods can be used according to the preferences of the individual managers for an initial evaluation of a project.
However, no method of investment appraisal can be completely accurate as they are
Open Document